<PAGE>

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC 20549

                                   FORM 10-K
                     _____________________________________

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF  1934

For the fiscal year ended December 31, 2000

                                      OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from _________  to ___________

                        Commission File Number: 0-22944

                         CAPSULE COMMUNICATIONS, INC.
                         ----------------------------
            (Exact name of Registrant as specified in its charter)

          Delaware                                     22-3055962
-------------------------------                        ----------
(State or other jurisdiction of            (I.R.S.  Employer Identification No.)
incorporation or organization)

2 Greenwood Square, 3331 Street Road, Suite 275
Bensalem, Pennsylvania                                        19020
-----------------------------------------------               -----
(Address of principal executive offices)                    (Zip Code)

(Registrant's telephone number, including area code):      (215) 633-9400
                                                           --------------

Securities registered pursuant to Section 12 (b) of the Act:    None
                                                                ----

Securities registered pursuant to Section 12 (g) of the Act:

                        Common Stock ($0.001 par value)
                        -------------------------------
                               (Title of Class)

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports); and (2) has been subject to such
filing requirements for the past 90 days.

                         Yes       X           No
                               ---------            ---------

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.


                                       2
<PAGE>

As of March 12, 2001 the market value of the Company's Common Stock held by non-
affiliates of the Registrant, based on the average closing sale price, was
approximately $5,300,000.

As of March 12, 2001 the Registrant has 22,667,444 shares of Common Stock
outstanding.


                                       3
<PAGE>

                               TABLE OF CONTENTS


                                    PART I
                                    ======

Item 1.    Business..........................................................  5
Item 2.    Properties........................................................ 11
Item 3.    Legal Proceedings................................................. 11
Item 4.    Submission of Matters to a Vote of Security Holders............... 12

                                    PART II
                                    =======

Item 5.     Market for the Registrant's Common Equity and Related
               Stockholder Matters........................................... 13
Item 6.     Selected Financial Data.......................................... 14
Item 7.     Management's Discussion and Analysis of Financial Condition
               and Results of Operations..................................... 15
Item 7A.    Quantitative and Qualitative Disclosure About Market Risk........ 18
Item 8.     Financial Statements and Supplementary Data...................... 18
Item 9.     Changes in and Disagreements with Accountants on Accounting
               and Financial Disclosure...................................... 18

                                   PART III
                                   ========

Item 10.    Directors and Executive Officers of the Registrant............... 19
Item 11.    Executive Compensation and Options Outstanding................... 20
Item 12.    Security Ownership of Certain Beneficial Owners and Management... 22
Item 13.    Certain Relationships and Related Transactions................... 24

                                    PART IV
                                    =======

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K.... 25


                                       4
<PAGE>

                                     PART 1
                                     ==== =

Item 1.   Business

Description of Business

Capsule Communications, Inc. ("the Company")  or "Capsule" is a switch-based
interexchange carrier providing long distance telephone communications services
primarily to small and medium-sized businesses and residential customers. The
Company offers 1+/800 long distance service (intrastate, interstate and
international termination), local (Verizon Reseller and UNE-P CLEC) services,
calling cards, international origination calling cards, pre-paid calling cards,
conference calling, cellular (as Verizon Reseller), nationwide paging, private
line and frame relay services and DSL Internet access. The Company uses its own
switches and facilities to originate, transport and terminate calls for
customers generally located between Maine and Norfolk, Virginia and in
California (on-net area).   Approximately 85% of the calls billed by the Company
each month are processed through the Company's own switches as of December 31,
2000.  For calls originating or terminating outside the Company's own network
(off-net area), the Company utilizes the services provided by other long
distance companies.

The Company's revenues are derived primarily from the transport of outgoing and
incoming calls, which are direct billed by the Company to end-users at specified
rates.  Access, egress, off-net transport and termination costs of these calls
are billed to the Company from underlying service providers at tariffed rates.
These carriers supply the Company with call detail information, which enables
the Company to bill its customers based upon the Company's retail rate plans.
The efficiency of the Company's network facilities, along with purchase of long
distance services in bulk from other carriers allows the Company to offer
competitive rates to small and medium-sized businesses and residential
customers.

The Company's principal executive offices are located at 2 Greenwood Square,
3331 Street Road, Suite 275, Bensalem, Pennsylvania 19020.  The Company's
telephone number at that location is (215) 633-9400.

The Company was incorporated in February 27, 1990 in New York as US WATS, Inc..

On May 3, 2000, the Company reincorporated in the State of Delaware as Capsule
Communications, Inc.  The Company was formerly known as US WATS, Inc.  As part
of this reincorporating merger, the Company increased the number of authorized
shares of common stock of the Company from 30,000,000 to 100,000,000 and the
number of authorized shares of preferred stock of the Company from 1,000,000 to
2,000,000.

On September 18, 2000, the Company signed a non-binding letter of intent to be
acquired by Startec Global Communications, and on November 2, 2000 entered into
a  Merger agreement with Startec.   Under the terms of the merger, subject to
certain price adjustments, Startec was to issue approximately 2.7 million shares
of its common stock to shareholders of Capsule.  In addition, Startec was to
have issued an aggregate of $3 million in 5-year, unsecured promissory notes to
two Capsule shareholders owning approximately 74% of the issued and outstanding
shares of Capsule.  On January 25, 2001, the Company announced that it had
terminated the merger agreement with Startec. In its notice of termination, the
Company asserted that Startec had breached various representations, warranties
and covenants in the merger agreement. On that same day, Startec Global
Communications Corporation announced that it served Capsule Communications with
notice of breach of the merger agreement. On March 12, 2001 Capsule and Startec
jointly announced that they had resolved all issues resulting from the
termination of the merger agreement. Both parties have released each other from
any liability and are continuing with their separate business plans. To reflect
differences in incurred merger expenses, Startec will make a series of payments
to Capsule over the next few months totaling $400,000 in the aggregate. Capsule
received $100,000 on March 15, 2001 as the first payment.

On March 5, 2001, the Company announced that it received notification from
NASDAQ on February 26, 2001 that the Company was no longer in compliance with
the minimum net tangible assets requirement for continued listing on The NASDAQ
SmallCap Market set forth in Marketplace Rule 4310(c)(2)(B). NASDAQ decided to
delist the Company's securities from The NASDAQ SmallCap Market at the opening
of business on March 6, 2001. The Company determined not to appeal the NASDAQ
decision, and effective March 6, 2001, the Company's securities began to trade
on the OTC Bulletin Board under the symbol "CAPS.OB."

On March 28, 2001 Gold & Appel, the company's largest shareholder, sold a
majority ownership interest (15,471,301 shares) in the Company at a price of
$.20 per share for a total amount of $3,094,260. The purchaser is also the
chairman of another publicly traded telecommunications company. The Company has
received a letter of interest


                                       5
<PAGE>

from this other telecommunications company regarding a possible merger. However,
there can be no assurances that a merger agreement will be negotiated on
favorable terms to the Company, or that a merger will occur at all.

There are 22,667,444 shares outstanding and 2,075,000 options (at an average
excise price of $1.37) outstanding.


                                       6
<PAGE>

Corporate Strategy

The Company is pursuing a business strategy, which will increase its efficiency
through network cost reductions, market penetration and a more efficient
business process. The Company's objective is to become a leading Integrated
Communications Provider ("ICP") focused on providing a core set of
communications services to small and medium-sized businesses and residential
customers who sign-up for service via one of the Company's web-enabled
"paperless" provisioning sites, or via traditional paper orders.  In 2001,
management has set out to accomplish Three primary objectives:

(1.) Continue to develop the systems and implement the systematization necessary
     to remain the performance leader in e-commerce, web enabled order entry.
(2.) Continue to grow the size of the Company's customer base and number of
     minutes switched and billed through its network.
(3.) Envision, energize and enact all of the Company's human resources to
     achieve their ultimate goals.

The Company believes that it will achieve market penetration and revenue growth
by focusing its efforts principally on small and medium-sized customers,
offering a core set of integrated communications services that are easy to
obtain.  The Company markets through proven sales channels, including
independent agents and switchless resellers/rebillers, coupled with its "Point-
Click-Collect" Internet sales web sites, and its Carrier Services department.
The sales channels and Internet sales web sites have been designed with
scaleable infrastructures to facilitate rapid expansion of the Company's sales
and marketing efforts.  The Company offers competitive retail rates and residual
commissions to the independent agents who choose to represent the Company.  The
Company expects to continue its efforts to expand this strategy in order to
generate new business/additional minutes of usage.  More minutes of usage spread
over the Company's existing fixed costs will reduce the Company's network costs
as a percentage of revenue and increase the Company's gross margin.

In an effort to pursue its strategy, the Company entered into a Loan Agreement
with Gold & Appel Transfer, S.A. ("G&A"), a majority shareholder of the company.
The terms of the agreement calls for the Company to borrow up to $900,000 at a
rate of 12% per annum, due and payable on June 15, 2002. The agreement allows
G&A to convert all or any portions of the loan amount to shares of the Company's
Common Stock at the average trading price for 20 days up to the conversion date
at any given time during the loan period. The Company borrowed the first
$300,000 on March 15, 2001. The remaining two $300,000 borrowings are required
to be paid by May 1, 2001 and June 15, 2001 respectively. However, at the
Company's option these borrowings may be made at a later date. This loan
agreement violates one of the restrictions in the Company's $2,000,000 credit
facility with Wells Fargo Credit Corporation. The Company has not yet received a
waiver of such condition of non-compliance.

Services

The Company offers 1+/800 long distance service (intrastate, interstate and
international termination), local (Verizon Reseller and UNE-P CLEC) services,
calling cards, international origination calling cards, pre-paid calling cards,
conference calling, cellular (as Verizon Reseller), nationwide paging, private
line and frame relay services and DSL Internet access.

The Company charges its customers based upon minutes of usage, at predetermined
intrastate, interstate and international rates based on the origination and
termination of a call. The Company is a "RESPORG" (Responsible Organization) for
the inbound 800 services it provides to its customers.  As a RESPORG, the
Company has direct access to the 800 number database allowing for efficient
provisioning of 800 number service.  This increases the speed at which the
Company can perform such services as blocking and routing changes for its
customers' inbound 800 services.

The Company utilizes Verizon Wireless to carry its cellular, and local services.
The Company provides its cellular customers with competitive long distance
services provided by its own network. The Company's travel cards provide its
customers with an "easy-to-remember" 800 number for accessing the Company's
network from all locations in the United States and Canada, and feature personal
identification numbers ("PINs"), which are selected by the individual customer.
The Company's prepaid calling cards (debit cards) are marketed wholesale
primarily to retail distribution and specialty advertising outlets.

The Company is a Competitive Local Exchange Carrier ("CLEC") through the resale
of Verizon local services. The Company purchases local services from Verizon and
resells to its customers. The Company is invoiced from Verizon at


                                       7

<PAGE>

a discount of the selling price. The Company is a certified UNE-P CLEC in the
states of Pennsylvania, Maryland, Delaware, New Jersey and Virginia and the
District of Columbia.

Switch and Network Facilities

The Company maintains a digital network on both the East and West coasts of the
United States.  The Company's East Coast network extends from Maine to Norfolk,
Virginia and west to Pittsburgh, Pennsylvania.  The Company's west-coast network
extends from California to Phoenix, Arizona and parts of Nevada.  The Company's
switching facilities are located in Philadelphia, Pennsylvania and Oakland,
California.  Calls originating on-net and terminating off-net are terminated via
underlying carriers through the Company's least cost routing technology.

The Company owns and operates two Digital Switch Corporation switches, a DEX
600E MegaHub and a DEX 600 in Philadelphia, PA, and Oakland, CA, respectively.
The Company's switches provide connectivity to the networks of nationwide
interexchange carriers and Regional Bell Operating Companies.  Both of the
Company's switches utilize SS7 ("Signaling System Seven") technology, which
increases network efficiency by reducing call set-up times.   The Company is in
the process of decommissioning its Oakland, CA network. The Company anticipates
this will reduce network costs as a percentage of revenue. The DEX 600 switch
will remain in place, but a more cost effective transport method over another
carrier's  network will be more cost effective.

The Company also operates a NACT STX intelligent call-processing switch which
supports the Company's calling card and debit card applications. It also
utilizes Equinox Protector/Detector and telescope fraud protection software to
monitor and measure the numerous types of fraud prevalent in the
telecommunications industry. This switching platform provides customized voice
prompts and other enhanced services required by these products.  The ability of
the Company to transport calls over its Company-owned switches and leased
facilities allows the Company to maximize gross margins and control network
quality of service.

The Company regularly reconfigures its call processing through the utilization
of least-cost routing software.  This software assures that the Company routes
calls which terminate off-net, to the carrier vendor supplying the Company with
the lowest terminating cost.  The Company has contracted with numerous domestic
and international transport carriers, which allows for international, country-
specific, least-cost routing and the maintenance of diverse routes.

Marketing

The success of the Company depends on its ability to attract and retain
customers.  While the technology and network sides of the business are critical,
and significant attention must be paid to the purchasing, installation and
ongoing management of the switch and data equipment and network, the company is
sales driven.  The Company utilizes a number of channels to distribute its
products and services, including,

        .      Indirect channel of independent Agent and Reseller/Rebillers.
        .      In house Telemarketing.
        .      Commercial Account Management (aftermarket local sales).
        .      Carrier sales channel.

Through the aforementioned channels, the Company principally sells voice
services to small and medium-sized business and residential accounts that do not
typically have dedicated in-house telecommunications professionals and have
responded well to its relationship driven consultative sales approach. The
Company employs several salaried agent recruiters, and a number of commission
only agent recruiters (Master Agents), who themselves recruit suitable agents
and/or resellers/rebillers to solicit and secure end-user accounts. The Company
believes that the most effective and expedient manner to solicit small and
medium sized business and residential accounts) for the Company's network is
through the support of the Company's non-certified independent agent Program.
The Company's very successful agent program pays agents commissions equal to a
percentage of their revenue billed. The Company's agent program offers a variety
of switched and dedicated retail rate plans and corresponding commission
percentages.  The program has been structured to offer agents flexibility and
choice in determining the best retail rate/commission plan for the circumstance.
The Company's agent eliminates certain hurdles in the sales process, eliminates
certain risks to the traditional reseller/rebiller programs, and rewards those
Agents who perform, offering the technical platform for them to manage their
business.

The Company has developed an in-house telemarketing group focused on soliciting
end-user's prospects who have entered one of the Company's Internet sales
portals and left with out signing-up for service. Follow up on "warm" leads
generated from the Company's web portals has proven to be an effective way to
secure new accounts. As the Company grows its retail customer base through its
indirect and in-house telemarketing sales channels, it will


                                       8
<PAGE>

continue to develop a ready audience to which it will market new products and
services. The Company maintains relationships with its embedded customer base of
end-user customers and active agents through proactive functions of its
Commercial Account Management Department. The Company's commercial account
managers, "CAMs", develop long-term business relationships with its customers,
the customers of its Agents, and its Agents and Resellers. Through customer
contact, site visits and surveys, the CAMs develop loyalty. The sale of new
products such as nationwide paging, Internet, cellular DSL, web hosting and
local services to existing customers are procured through this channel.

The Company offers its customers a comprehensive invoice.  Included in the
Company's invoices are more than 20 management reports covering call
distribution studies, time of day analysis, call duration distribution, and
individual telephone number call detail records allowing them to quickly analyze
their calling patterns and costs. In October 2001 the Company rolled out its
online invoice, allowing the customer to view the invoice through the Company's
customer service web site. From this site, the customer can choose to pay their
invoice automatically each month with a credit card and manage their invoices
and payments 100% electronically.

As of December 31, 2000, the Company's average retail customer used
approximately $89 in monthly long distance service, which is similar to the
industry average for revenue generated through an agent sales force.

The Company's Carrier Services Division has refocused its marketing initiatives,
primarily pursuing northeast regional traffic to help amortize the fixed cost of
existing network within the region, and international termination's from
carriers whose primary business is retail residential and/or commercial
business.  Desirable domestic and international minutes of usage are attracted
through strategic pricing. Emphasis is directed toward more stable regional
ILEC, CLEC's, and switched based Resellers whose primary marketing efforts are
retail.   The Company moved away from selling commodity-based minutes of use to
carriers at very low margin.  In 2000, the Company's carrier traffic decreased $
2,328,942 in conjunction with the retail minutes increasing greater than 50
million. Clearly the decline in average-call-charges is an ongoing concern for
the industry. However, the growth in retail minute usage of greater than 50
million in 2000 has offset the decline in long distance rates to a large extent.
Going forward, management expects that the Company could potentially benefit
from declining industry margin as a result of its very efficient execution and
fulfillment platform.

Competition

The Company views the long distance industry as a three-tiered industry, which
is dominated by the nation's three largest long distance providers: AT&T,
MCIWorldCom and Sprint Corporation  ("Sprint"). Based on industry data, the
Company believes that AT&T, MCIWorldCom and Sprint, collectively generate
approximately 80% of the nation's interexchange long distance revenue
(approximately $118 billion during 1999) and comprise what is known as "Tier 1"
International Long Distance Companies.  The second tier consists of several
other companies with annual revenues of $250 million to $5 billion each.  The
third tier, which includes the Company, consists of more than 500 companies with
annual revenues of less than $250 million each, the majority below $50 million
each.

The Company targets small and medium-sized commercial and residential customers.
The number of telecommunications services offered by the Company on a
consolidated, one-bill basis serves to some extent distinguishes the Company
from some of its competitors.  Competitive distinctions are made based upon the
number of services offered, the pricing plans, the length of contracts, as well
as the billing information provided.  The Company currently owns switch
capacity, develops and implements its own products, monitors and deploys its
transmission facilities and prepares and designs its own billing and reporting
systems.

In addition to direct competition from what the Company estimates are several
hundred switchless resellers, the Company competes with the sales organizations
and resellers of large telecommunications companies such as AT&T, MCIWorldCom
and Sprint, which at any particular time may offer more desirable services or
prices than those offered by the Company. With recent approval granted by the
FCC, the Company also competes  against certain Regional  Bell Operating
Companies to provide in-region long distance service.

On October 29, 1996, the FCC adopted an order in which it eliminated the
requirement that non-dominant interstate carriers such as the Company maintain
tariffs on file with the FCC for domestic interstate interexchange services.
The FCC's order was issued pursuant to authority granted to the FCC in the
Telecommunications Act to "forebear" from regulating any telecommunications
service provider if the FCC determines that the public interest will be served.
Pursuant to the FCC's order, after a transition period, relationships between
carriers and their customers would be set by contract and long distance
companies would no longer be permitted to file with the FCC tariffs for
interstate interexchange services.  However, MCI, Sprint and The American
Carriers Telephone Association have separately


                                       9
<PAGE>

appealed the FCC's order to the United States Court of Appeals for the District
of Columbia Circuit ("DC Circuit"). On February 13, 1997, the DC Circuit stayed
the FCC's detariffing rules. These rules remain subject to pending appeals. The
Company may benefit from the elimination of FCC tariffs by gaining more
flexibility and speed in dealing with marketplace changes. However, the absence
of tariffs will also require that the Company secure contractual agreements with
its customers regarding many of the terms of its existing tariffs or face
possible claims arising because of the rights of the parties are no longer
clearly defined. In addition, to the extent disputes arise over such contracts,
carriers without tariffs may no longer resort to the legal doctrine that the
terms of a filed tariff supersede individual contract language.

In spite of AT&T's additional flexibility and the expected increased
interexchange competition from the Regional Bell Operating Companies, the
Company believes that it continues to provide and sell telecommunications
service to small to medium sized businesses and individuals at competitive
rates.  In addition, the Company believes that the deregulation of the local
exchange telecom market represents a significant opportunity similar to the
opportunity provided at the breakup of AT&T in 1984.

Employees

At the end of 2000, the Company had 79 full-time employees working at three
locations.  The majority of the employees work at the Company's principal
executive offices located at 2 Greenwood Square, 3331 Street Road, Suite 275,
Bensalem, Pennsylvania 19020.  The Company is not a party to any organized labor
contracts.  The Company considers its relationship with its employees to be
satisfactory.

Regulatory Matters

Regulatory Requirements.  The Company is a regulated entity at the Federal level
with regard to international traffic and interstate traffic.  The Company has
received Section 214 authorization to resell international switched services and
has filed an FCC tariff for its domestic interstate services.

State regulatory requirements vary from state to state.  The Company has
obtained certification in all states, which require certification in order to
provide resold long distance services, with the exception of Alaska, Colorado
and Hawaii.  Additionally, the Company's application for certification in
Arizona is currently pending.  The Company is also authorized to provide
competitive local exchange telecommunications services in six (6) states
(Pennsylvania, New Jersey, Delaware, Maryland, Virginia and the District of
Columbia).  Some states place statutory restrictions on the operations of
telecommunications service providers, including requiring telecommunications
service providers to file and operate in accordance with service and rate
tariffs. Further, carriers are required to charge just and reasonable rates and
not discriminate among similarly situated customers.  Some states and the FCC
also require the filing of periodic reports, the payment of various regulatory
fees and surcharges, and compliance with service standards and consumer
protection rules.  Changes in existing regulations or their interpretation in
any state could subject the Company to increased regulation.  Such regulation
could result in an increase in customers' usage charges and, in some cases,
could limit or eliminate the Company's ability to service customers in that
jurisdiction.  The Company would incur, among other expenses, certain
administrative costs and legal fees in contesting or complying with such
regulatory changes that would increase the Company's cost of doing business.

The providers of local exchange telecommunications services to the Company are
also heavily regulated at the Federal level and in the states in which they
operate.  Changes in existing regulations or their interpretation affecting
these providers could materially adversely affect their business or even prevent
them from offering telecommunications services to their customers, including the
Company, on favorable terms.

In addition, certain services offered by the Company, which are not presently
regulated in all states may become regulated.  Such regulation could delay the
deployment of products and/or services and would increase certain administrative
costs and legal fees in contesting or complying with such regulation.  The FCC
has granted applications by companies seeking to provide international callback
(also known as "call reorigination" services) to those countries where the
practice is legal under local law.  The FCC has taken the view that call
reorigination services created incentive to lower foreign accounting rates to
the benefit of U.S. ratepayers, while serving the FCC's general policies
favoring resale and increased competition in the international marketplace.
Although the FCC has consistently expressed its support for call reorigination
services enacted by foreign countries, in response to the input of certain
foreign countries in rulemaking proceedings, the FCC has acknowledged that
foreign countries face unusual difficulties in implementing prohibitions on call
reorigination, while the FCC has stated that such countries continue to


                                       10
<PAGE>

bear the principal responsibility for enforcing their domestic laws. However, as
a matter of international comity, the FCC will prohibit U.S. authorized carriers
from providing call reorigination in countries where it is expressly prohibited.
The FCC established a variety of requirements that a foreign country must meet
before the FCC will consider assisting a foreign government in enforcing its
domestic ban. To date, the FCC has taken no direct enforcement action against an
individual carrier to enforce a foreign country's ban with respect to a U.S.
provider. However, there can be no assurance that the FCC or foreign governments
will not enforce such a ban.

Legislation.   On February 8, 1996, President Clinton signed into law the
Telecommunications Act of 1996 (the "1996 Act").  The bill was intended to spur
additional competition in telecommunications services particularly within the
local exchange markets, which are now dominated by incumbent local exchange
carriers.

The 1996 Act codifies a new set of interconnection principles, applicable to
interconnection for both interstate and intrastate services.  State public
utilities commissions are given a significant role in administering the
interconnection provisions of the Act, and deadlines are imposed for decisions
by both the FCC and state commissions.  On August 8, 1996, the FCC released the
Interconnection Decision which established a framework of minimum, national
rules enabling state commissions and the FCC to begin implementing many of the
local competition provisions of the 1996 Act.  Among other things, the
Interconnection Decision prescribed certain minimum points of interconnection;
adopted a minimum list of unbundled network elements that ILECs must make
available to competitors; and adopted a methodology for states to use when
setting prices for unbundled elements and for wholesale resale services.  On
January 25, 1999, the Supreme Court overturned prior decisions of the United
States Court of Appeals for the Eighth Circuit that had vacated certain portions
of the Interconnection Decision.  The Supreme Court's decision confirmed the
FCC's authority to issue regulations implementing the pricing and other
provisions of the 1996 Act and reinstated most of the challenged rules.  The
Supreme Court decision, however, vacated a key FCC rule that identified the
network elements that ILECs must unbundle.  The FCC has since adopted a new
standard for analyzing unbundled network elements, as required by the Supreme
Court.  The FCC concluded that ILECs would no longer be required to provide
directory assistance and operator services as network elements, although they
will continue to be available pursuant to tariffed rates.  The FCC declined,
however, except in limited circumstances, to require ILECs to unbundle certain
facilities used to provide high-speed Internet access and other data services.
Uncertainty remains regarding the effect of the Eighth Circuit decisions, the
decision of the Supreme Court reversing portions of it, and subsequent
proceedings.

The 1996 Act also eliminates the existing AT&T antitrust consent decree, which
barred the provision of long distance services and manufacturing by the Regional
Bell Operating Companies (RBOCs).  Under the act, RBOCs may immediately offer
long distance services outside their home regions.  The RBOCs may offer service
within their regions upon FCC approval based on a showing that facilities-based
competition and interconnection agreements meeting a 14-point checklist both
exist.  On December 22, 1999, the FCC granted Bell Atlantic's application to
offer in-region long distance services in New York, marking the first time since
the breakup of AT&T that a BOC is able to provide its customers with both local
and long distance service.

In 1997, the FCC released an order establishing a significantly expanded federal
universal service subsidy regime.  Specifically, the FCC established new
universal service funds to support telecommunications and information services
provided to qualifying schools, libraries and rural health care providers, and
expanded the federal subsidies for local telephone services provided to low-
income consumers.  The FCC collects money to fund this expanded regime from
interstate carriers and certain other entities.  Contribution factors vary
quarterly and are passed on by the Company to end users. Recently the United
States Court of Appeals for the Fifth Circuit rejected the FCC's effort to base
contributions in part on intrastate revenues.  The FCC's universal service
program may be altered as a result of appeals, agency reconsiderations of its
actions, or future Congressional action.

Additional competition with incumbent local exchange carriers ("ILECs") should
provide price discipline in an area which has been monopolized by ILECs.  The
Company can also expect a substantial increase in the competition, which it
faces in interexchange markets as a result of the entry of the BOCs into long
distance services.  Not only will there be additional competition providing
services which are similar to those provided by the Company, but they can be
expected to bundle those services with other offerings such as local service,
cellular and video services.  These package offerings may be more attractive to
consumers than offerings of stand-alone services.

Access/Egress Charges.  The cost of providing long distance and local exchange
services will be affected by changes in the access/egress charges imposed by
RBOC's, ILECs, and Competitive Local Exchange Carriers (CLEC's) for origination
and termination of calls over local facilities.  The term "access/egress
service" describes the use of local exchange facilities for the origination and
termination of interexchange communications.  On May 8, 1997, the FCC


                                       11
<PAGE>

released an order intended to reform the FCC's system of interstate access
charges to make that regime compatible with the pro-competitive deregulatory
framework of the 1996 Act. The FCC's access reform order adopts various changes
to federal policies governing interstate access service pricing designed to move
access charges, over time, to more economically efficient levels and rate
structures. Among other things, the FCC modified rate structures for certain no-
traffic sensitive access rate elements, moving some costs from a per-minute-of-
use basis to flat-rate recovery, changed its structure for interstate transport
services, and affirmed that interstate access charges do not apply to Internet
service providers. On August 18, 1998 the Eighth Circuit affirmed the FCC's
access reform order.

In response to claims that existing access/egress charge levels are excessive,
the FCC stated that it would rely on market forces first to drive prices for
interstate access to competitive levels but that a "prescriptive" approach might
be considered if necessary.  In the absence of competition, the FCC stated that
it might specify the nature and timing of changes to existing access rate
levels.  On August 5, 1999, the FCC adopted an order granted ILECs additional
pricing flexibility, implementing certain access charge reforms, and seeking
comments on others.  The order provides a framework of "triggers" to provider
those companies with greater pricing flexibility to set interstate access rates
as competition increases.  The order also initiated a rulemaking to determine
whether the FCC should regulate the access/egress charges of CLECs.  If this
increased pricing flexibility for price cap ILECs is not effectively monitored,
or if the FCC regulates CLEC access charges, it could have a material adverse
impact on our ability to price our own interstate access services competitively.
As of January 1998, access charges incurred by the Company are being passed on
to end users.

On March 31, 1999, the FCC released its Collocation Order which requires ILECs
incumbent carriers to permit CLECs to collocate any equipment used for
interconnection or access to unbundled network elements even if that equipment
includes switching or enhanced service functions.  Among other things, the
Collocation Order also prohibits ILECs from placing any limits on the use of
switching or enhanced features for collocated equipment, and requires ILECs to
make cageless collocation available and permit CLECs to construct their own
cross-connect facilities.

On March 17, 2000, the United States Court of Appeals for the District of
Columbia Circuit vacated limited portions of the Collocation Order, holding
certain definitions contained in FCC rules were impermissibly broad.  The court
remanded the Collocation Order in part for further FCC consideration of these
issues.  The FCC will be instituting proceedings to comply with the court's
remand.

Also, as part of Access Reform mandated in the Telecommunications Act of 1996,
beginning in 1998, local phone companies are permitted to assess the Pre-
subscribed Interexchange Carrier Charge, also known as "PICC."  The "PICC" is a
monthly per line cost charged by the local telephone company to each long
distance carrier for every business customer phone line that is pre-subscribed
to that carrier.  These charges are passed on to the end users.

Telecommunication Fraud

The Company is subject to attempts by outsiders to gain access to the Company's
telecommunications network.  Such attempts can take the form of the theft of
calling cards, and the cloning of cellular phones.  Breaches of security can
also involve improper use of 800 telephone numbers and customer PBX equipment.
The Company monitors the use of its network through certain fraud detection
devices and believes that its procedures are satisfactory.  Due to the highly
technical nature of the business, complete assurance that sufficient controls
are in place to prevent a material loss is not possible, however; the Company
does not believe that it has been subject to material telecommunications fraud.

Item 2.  Properties

The Company currently leases approximately 20,500 square feet in three buildings
at a total monthly cost of approximately $38,000.  Its executive offices and
headquarters at 2 Greenwood Square, 3331 Street Road, Suite 275 in Bensalem,
Pennsylvania are leased for a term of three years expiring in August, 2001. The
Company has chosen to renew its lease for a term of three years ended August
2004.  The Company's leased switch space in Philadelphia, Pennsylvania expires
in March 2007.  The Company's leased switch space in Oakland, California expires
in September 2002.   The Company considers its space to be adequate for its
current needs.

Item 3.  Legal Proceedings

On June 13, 1997, Mark Scully, a former President and Chief Operating Officer of
the Company, filed a complaint against the Company, Kevin O'Hare, Aaron Brown
and Stephen Parker in the United States District Court for the Eastern District
of Pennsylvania.  Mr. Scully asserted various claims in connection with his
termination of employment


                                       12
<PAGE>

with the Company on December 30, 1996. In particular, he alleged, among other
things, breach of contract in connection with the termination of certain stock
options, breach of the alleged contract for employment, breach of an asserted
duty of good faith and fair dealing, fraudulent and negligent misrepresentation,
and civil conspiracy. Mr. Scully alleged damages of at least $1.6 million, plus
attorneys' fees, costs and other disbursements and the cost of COBRA payments
and interest; $1 million of the alleged damages claimed are punitive. On June 9,
1999, the Court issued its decision and judgment was entered in favor of Mr.
Scully and against the Company and two former officers for the sum of
approximately $626,000 and required the Company to establish an escrow account
equal to 120% of the judgment. The Court denied Mr. Scully's claim for
attorneys' fees and liquidated damages. The Company appealed the decision, and
on February 1, 2001 the appeals court reaffirmed the lower court's decision and
judgment was entered in favor of Mr. Scully and against the Company and two
former officers for the sum of $1,080,000 which consisted of the original award
of $626,443 in damages plus legal expenses and interest. The Company ultimately
settled with Mr. Scully for $1,030,000. The company recorded expense for this
litigation of $404,000, $326,000 and $300,000 for 2000, 1999 and 1998
respectively. In 1999 the Company was required to establish an escrow account to
provide for damages, and the balance in these escrow accounts at December 31,
2000 and 1999 was $823,571 and $770,363 respectively, and is recorded as
restricted cash.

The Company is party, in the ordinary course of business, to other litigation
involving services rendered, contract claims and other miscellaneous causes of
action arising from its business.  The Company has established reserves relating
to its legal claims and believes that potential liabilities in excess of those
recorded will not have a material adverse effect on the Company's Consolidated
Financial Statements, however, there can be no assurances to this effect.

Item 4.  Submission of Matters to a Vote of Security Holders

Not applicable


                                       13
<PAGE>

                                    PART II
                                    ==== ==


Item 5.  Market for the Registrant's Common Equity and Related Stockholder
Matters

The following figures represent the high and low closing price as reported by
NASDAQ during each successive quarter beginning in 1999.


       QUARTER                  HIGH        LOW
       -------                  ----        ---

     4th     Quarter 2000      $ 1.84      $ 0.19
     3rd     Quarter 2000      $ 1.44      $ 0.91
     2nd     Quarter 2000      $ 2.00      $ 0.94
     1st     Quarter 2000      $ 3.57      $ 1.75
     4th     Quarter 1999      $ 2.63      $ 1.53
     3rd     Quarter 1999      $ 2.06      $ 1.31
     2nd     Quarter 1999      $ 1.91      $ 1.19
     1st     Quarter 1999      $ 2.69      $ 1.63


Effective January 21, 1994, the Company's Common Stock was listed on the NASDAQ
Small Cap Market under the symbol "USWI".  On May 1, 2000 the Company
reincorporated in Delaware under the name of Capsule Communications Inc., and
was listed as "CAPS" on the NASDAQ Small Cap Market. On March 9, 2001, the
Company was no longer traded on The NASDAQ by will be traded on the On the Over
The Counter Market "OTC" under the symbol "CAPS.OB".

As of March 7, 2000 there were approximately 122 holders of record of the
Company's Common Stock.

The Company has not paid any dividends on its Common Stock.  However, the
Company paid quarterly dividends on its Preferred Stock at a rate of 9%
annually, or approximately $6,750 per quarter for the first two quarters of
1999.  On July 1, 1999 the company's sole preferred shareholder converted all of
his 30,000 Preferred Shares into 300,000 Common Shares.  The Company does not
currently anticipate the payment of dividends on its Common Stock.

On May 19, 2000, the Company, through a private placement transaction, issued
666,667 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, in full payment of a loan obligation to Gold & Appel
with an original principal amount of $1,000,000.  The terms of the transaction
were negotiated between the Company and Gold & Appel Transfer, S.A. on an arms
length basis, with Mr. Anderson, the controlling party of Gold & Appel, and also
a director of the Company.

On May 19, 2000, the Company the Company through a private placement
transaction, issued 333,333 shares of Common Stock to the Foundation for the
International Non-Governmental Development of Space, a non-profit organization
("FINDS"), of which Mr. Anderson is the president and director, in full payment
of a loan obligation to FINDS with an original principal amount of $500,000.
The terms of the transaction were negotiated between the Company and FINDS on an
arms length basis, with Mr. Anderson, and also a director of the Company.

On June 30, 2000, the Company, through a private placement transaction, issued
720,000 shares of Common Stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $900,000 or $1.25
per share.  The proceeds of the issuance were used for general working capital.
The terms of such transaction were negotiated between the Company and Gold &
Appel Transfer, S.A. on an arms length basis, with Mr. Anderson abstaining from
all negotiations and approvals.


                                       14
<PAGE>

All share shares issued in 2000 were issued directly by the Company to the
holders without an underwriter or placement agent and were issued without
registration under the Securities Act of 1933 pursuant to the private placement
exemption contained in Section 4(2) of the Securities Act.

Acquisition

On March 17, 2000, the Company purchased certain assets of the business of Cam-
Comm, Inc. At the time of the transaction, James Rossi was the chairman of the
Company and owned Cam-Comm. The Company acquired the customer base and accounts
receivable of $83,876 private line customers from Cam-Comm, Inc. in exchange for
a cash payment of $150,000 and an agreement to pay an amount of $76,405 for an
outstanding liability of Cam-Comm, Inc. Goodwill of $142,529 was recorded and
will be amortized over three years.

Item 6.  Selected Financial Data

The selected financial data presented below is for the years ended December 31,
for each of the periods indicated below.  The following information should be
read in connection with the consolidated financial statements of the Company and
related notes included elsewhere in this report and with Item 7 of this report.

<TABLE>
<CAPTION>
                                                               Year ended December 31,
                                                               -----------------------

                                          2000           1999           1998           1997          1996
                                          ----           ----           ----           ----          ----
<S>                                   <C>            <C>            <C>            <C>            <C>
Operating Data
--------------
Net sales                              $37,368,359    $39,777,331    $44,679,060    $56,466,698   $40,304,442

Net income (loss) (1)                  $(4,763,770)   $(2,950,899)   $(1,828,369)   $(3,699,821)  $    88,625

Net income (loss) per
     Common share (2)                  $      (.22)   $      (.15)   $      (.10)   $      (.23)  $        --
</TABLE>
<TABLE>
<CAPTION>
                                                                   December 31,
                                                                   ------------
Balance Sheet Data                       2000           1999           1998           1997          1996
------------------                       ----           ----           ----           ----          ----
<S>                                   <C>            <C>            <C>            <C>            <C>
Total assets                           $11,158,446    $10,906,213    $11,021,464    $11,813,475   $11,992,359

Capital lease obligations              $         0    $   153,289    $   376,760    $   653,355   $   703,696

Redeemable preferred stock             $         0    $         0    $   330,000    $   330,000   $   300,000

Cash dividends on preferred
     Stock                             $         0    $    13,500    $    27,000    $    27,000   $    27,000
</TABLE>

(1)  1997 results include an increase in bad debt expense of approximately
     $986,000 due to higher than anticipated carrier write-offs.  In addition,
     the Company incurred approximately $173,000 of severance expense upon the
     termination of three members of management during 1997.  Finally, costs
     associated with a proposed merger with ACC Corp. amounted to approximately
     $567,000 in 1997.

     1998 results include approximately $393,000 in additional depreciation
     expense due to the acceleration of depreciation of assets associated with
     the Philadelphia Switch, which was replaced in 1999.  In addition, the
     Company incurred approximately $300,000 of salary expense for severance
     paid to a former President.  Finally, approximately $102,000 in
     miscellaneous expenses were incurred in connection with the relocation of
     the corporate office in 1998.

     1999 results include an increase in bad debt expense of approximately
     $861,000 due to the write-off of a carrier account in the third quarter.
     Also, an additional legal accrual of approximately $376,000 was incurred
     for a lawsuit judgment (see footnote 12 of the financial statements).
     Finally, approximately $105,000 in additional depreciation expense was due
     to the acceleration of depreciation of assets associated with the old
     Philadelphia switch.


                                       15
<PAGE>

     The 2000 loss increase of approximately $1,800,000 is attributable to a
     reduction in gross profit and an increase in salaries form a line of
     business subsequently discontinued.

(2)  The Company has retroactively adopted Statement of Financial Accounting
     Standards No. 128, Earnings Per Share ("SFAS 128").  In accordance with
     SFAS 128, since the Company has incurred losses from continuing operations
     for the years ended December 31, 1997, 1998,1999 and 2000 no potential
     Common Shares have been included in the computation of any diluted per
     share amount.  For the year ended December 31, 1996 the difference between
     diluted and basic earnings per share is not significant.  Accordingly, only
     basic earnings per share have been presented.


Item 7.  Management's Discussion and Analysis of Financial Condition and Results
of Operations

Forward Looking Statements

This annual report on Form 10-K includes "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended and
Section 27A of the Securities Exchange Act of 1933, as amended. Financial
projections and words and phrases denoting the anticipated results of future
events, such as "anticipate", "believe","estimate", "expects", "may", and
"project" and similar expressions that denote uncertainty are intended to
identify forward looking statements and information. Such statements are subject
to certain risks and uncertainties, including but not limited to: changes in
general economic conditions, increasing levels of competition in the
telecommunications industry, changes in telecommunications technologies, changes
in FCC regulations, the Company's reliance on transmission facilities based
carriers, risks involved in conducting international operations, the inability
to generate sufficient revenues to meet debt service obligations and operating
expenses, unanticipated costs associated with the Company's recent and future
acquisitions and the failure of the Company to manage its growth effectively.
Should one or more of these risks or uncertainties materialize, actual results
may vary materially from those estimated, anticipated or projected.  Although
the Company believes that the expectations reflected by such forward-looking
statements are reasonable based on information currently available to the
Company, no assurance can be given that such expectations will prove to have
been correct.  All forward-looking statements included herein are expressly
qualified in their entirety by these cautionary statements.

RESULTS OF OPERATIONS

                            ~2000 Compared to 1999~

Revenue

Revenues decreased 6% or $2,408,972 for a total of $37,368,359 in 2000. This
decrease was a result of carrier revenue decreasing $ 2,328,942. Switched long
distance revenues remained constant, as the volume of minutes increased by
greater than 50,000,000. A reduction in the average rate of new sales declined.
kept the revenue level constant. The company entered into a new line of business
by offering local service through a resale of Verizon's services. This product
was first offered in August 2000, and produces $299,572 for 2000.

The table below shows the distribution of revenues on a percentage basis by
product line:

                            Distribution of revenues

               Service                            % 2000     % 1999
               -------                            ------     ------
               Domestic 1+                            56%        48%
               International                          22%        22%
               Inbound                                15%        17%
               Wireless                                2%         3%
               Domestic Carrier Termination            4%        10%
               Local                                   1%        --


Gross Profit

Gross profit margin decreased marginally from 29.1% in 1999 to 27.1% in 2000.
Gross profit decreased $1,442,207 in 2000.  This was primarily due to the
decrease in revenues and gross profit margin


                                       16
<PAGE>

Selling, General and Administrative expense

Selling, general and administrative ("SG&A") expenses for 2000 were $911,743
greater than the amount incurred during 1999.  However, SG&A expenses as a
percentage of revenue increased from 32.8% in 1999 to 37.3% in 2000. Salary
compensation expense increased approximately $1,040,209 to $3,980,947 primarily
due to new areas of business and system development initiatives. During the
first quarter of 2000 the Company developed a nationwide direct sales force
focused on securing the endorsement of local chambers of commerce, who in turn
were to secure the small and medium business that comprised its membership.
While the Company's network of salespersons successfully secured 65 chamber
relationships, it became evident that the chambers lacked the promotion
necessary to secure the retail revenue. The Company exited this business
strategy in 2nd quarter 2000. There was significant human resources allocated to
this strategy, thus accounting for a large portion of the salary increase.

Provision for Bad Debt

Bad debt expense decreased $738,575 (from 3.7% of net sales in 1999 to 1.9% of
net sales in 2000).  In 1999, the Company incurred bad debt expense of
approximately $861,000, related to a large carrier account, which contributed to
bad debt expense for the year of approximately $1,453,000 in 1999.

Net Loss From Operations

The Company recorded a net loss for 2000 of $4,763,770 compared to a net loss of
$2,964,339 in 1999. This was primarily due to a decrease in revenues and gross
profit, combined with the above referenced increase in salaries.

                            ~1999 Compared to 1998~

Revenue

Revenues decreased 11% or approximately $4,901,729 to $39,777,331 in 1999.  This
was primarily due to a decrease in revenue through the carrier sales channel of
approximately $1,338,000.  In 1999, the Company limited the amount of high-risk
international traffic in order to reduce bad debt exposure.  Also, there was a
decline in International Callback revenue of approximately $1,037,000.  As
deregulation occurs in European and Asian countries, the International Callback
business continues to diminish.  In addition, there was a decrease in retail
revenue of approximately $2,527,000.  As a result of strong competition in the
long distance marketplace, the Company's average retail rate per minute
decreased $.0194 from January 1, 1999 to December 31, 1999. This accounted for
approximately $2,360,000 of the decrease in retail revenue.


The table below shows the distribution of revenues on a percentage basis by
product line:

                            Distribution of revenues


                Service                      % 1999     % 1998
                -------                      ------     ------
                Domestic 1+                      48%        45%
                International                    22%        23%
                Inbound                          17%        15%
                Wireless                          3%         4%
                Carrier termination              10%        13%

Gross Profit

Gross profit margin increased marginally from 28.8% in 1998 to 29.1% in 1999.
Gross profit decreased approximately $1,308,000 in 1999.  This was primarily due
to the decrease in revenues.

Selling, General and Administrative expense

Selling, General and Administrative ("SG&A") expenses for 1999 were
approximately $813,000 lower than the amount incurred during 1998.  However,
SG&A expenses as a percentage of revenue increased  from 31.0% in 1998 to 32.8%
in 1999.   Depreciation expense decreased approximately $385,000 in 1999 due to
accelerating the depreciation of assets associated with one of the Company's
switches in 1998 (See footnote 2 of the financial statements).  Commission
expense decreased approximately $354,000 or 6.7% from 1998 due primarily to a
decrease in revenues on which commissions are paid. Salary compensation expense
decreased approximately $188,000 to approximately $2,857,000 primarily due to a
severance payment to a former president in 1998 of approximately $300,000.
Legal and consulting expenses increased approximately $243,000 primarily due to
fees associated with

                                       17
<PAGE>

potential strategic alternatives for the Company and the Company's pending
reincorporation merger into the state of Delaware. Also, other miscellaneous
SG&A expenses decreased approximately $129,000 in 1999.

Provision for Bad Debt

Bad debt expense increased approximately $665,000 (from approximately 1.8% of
net sales in 1998 to approximately 3.7% of net sales in 1999).  In 1999, the
Company incurred bad debt expense of approximately $861,000 related to a large
carrier account, which contributed to bad debt expense for the year of
approximately $1,453,000.

Net Loss From Operations

The Company recorded a net loss for 1999 of $2,950,899 compared to a net loss of
1,828,369 for 1998.  This was primarily due to a decrease in revenues, and an
increase in bad debt expense.  A portion of the net loss in 1999 was
attributable to the following:  bad debt expense of approximately $861,000
related to the write-off of a large carrier account, depreciation expense of
approximately $105,000 associated with accelerating depreciation of certain
assets (See footnote 2 of the financial statements), and a miscellaneous expense
of $376,000 associated with a legal judgment (See footnote 12 of the financial
statements).


Liquidity And Capital Resources

The consolidated financial statements of the Company have been prepared on a
going-concern basis, which contemplates the continuation of operations,
realization of assets and liquidation of liabilities in the ordinary course of
business. The Company incurred a net loss applicable to common shareholders of
approximately $4,763,770 during the year ended December 31, 2000 and had
negative cash flow from operating activities of $1,909,732.  At December 31,
2000 the Company had a net working capital deficit of $3,056,625 and an
accumulated deficit of $15,087,022.  In addition, the Company was not in
compliance with one of its covenants in its Loan and Security Agreement with
Wells Fargo Bank, however, the Company received a waiver related to such non-
compliance.  The Company can renew its line of credit arrangement with Wells
Fargo for one more year on May 11, 2001. The Company does not believe that its
events of non-compliance and subsequent waiver will affect its ability to renew
the line of credit. Such conditions raise substantial doubt about the Company's
ability to continue as a going concern.  The accompanying financial statements
do not include any adjustments that might be necessary should the Company be
unable to continue as a going concern.

The Company plans to focus on growing its revenue base through the addition of
profitable customers and decreasing its network costs.  The Company intends to
reduce its network costs by obtaining more favorable pricing from suppliers, by
forming strategic alliances with certain similarly situated companies,
increasing the network traffic on its fixed cost network, and also discontinuing
the operations located in Oakland California and using a more cost favorable way
to transport that existing traffic.

The Company expanded on its private Internet web sites from which its agents are
generating new orders electronically.  The Company expects to continue its
efforts to expand this strategy in order to generate new business. In addition
to these private Internet sites, the Company plans to implement an electronic
business-to-business strategy to reduce overhead costs associated with operating
its agent sales force channel.

Additionally, the Company began the resale of  local access services to its
current and prospective customers in six Bell Atlantic, now Verizon states under
its favorable interconnection agreements.

On May 19, 2000, the Company through a private placement transaction, issued
666,667 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, in full payment of a loan obligation with an
original principal amount of $1,000,000.  The terms of such transaction were
negotiated between the Company and Gold & Appel Transfer, S.A. on an arms length
basis, with Mr. Anderson, the controlling party of Gold & Appel, and a directory
of the Company, abstaining from all negotiations.

On May 19, 2000, the Company through a private placement transaction, issued
333,333 shares of Common Stock to the Foundation for the International Non-
Governmental Development of Space, a non-profit organization ("FINDS"), of which
Mr. Anderson is the president and director, in full payment of a loan obligation
with an original principal amount of $500,000.  The terms of such transaction
were negotiated between the Company and FINDS. on an arms length basis, with Mr.
Anderson, the controlling party of Gold & Appel, abstaining from all
negotiations.

On June 30, 2000, the Company, through a private placement transaction, issued
720,000 shares of Common Stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, and Foundation for the International Non-
Governmental Development of Space, a non-profit organization of which Mr.
Anderson is the president and director, for an aggregate purchase price of
$900,000 or $1.25 per share. The proceeds of the issuance are being used for
general working capital. The terms of such transaction were negotiated between
the Company and Gold & Appel Transfer, S.A. on an arms length basis, with Mr.
Anderson abstaining from all negotiations and approvals.

On March 15, 2001, Company entered into a Loan Agreement with Gold & Appel
Transfer, S.A. ("G &A"), a majority shareholder of the company. The terms of the
agreement calls for the Company to borrow up to $900,000 at a rate of 12% per
annum, due and payable on June 15, 2002. The agreement allows G&A to convert all
or any portions of the loan amount to shares of the Company's Common Stock at
the average trading price for 20 days up to the conversion date at any given
time during the loan period. The Company borrowed the first $300,000 on March
15. This loan agreement violates one of the restrictions in the Company's
$2,000,000 credit facility with Wells Fargo Credit Corporation. The Company has
not yet received a waiver of such condition of non-compliance.

On March 28, 2001 Gold & Appel, the company's largest shareholder, sold a
majority ownership interest (15,471,301 shares) in the Company at a price of
$.20 per share for a total amount of $3,094,260. The purchaser is the chairman
of another publicly traded telecommunications company. The Company has received
a letter of interest from this other telecommunications company regarding a
possible merger. However there can be no assurances that a merger agreement will
be negotiated in favorable terms to the Company, or that a merger will occur at
all.

The Company believes that the loan agreement, combined with its cost reductions
will be adequate to allow the company to continue its operations, however there
can be no assurances to this effect.

                                       18
<PAGE>

2001. The remaining two $300,000 borrowings are required to be paid by May 1,
2001 and June 15, 2001 respectively. However, at the Company's option these
borrowings may be made at a later date.

The company was not able to meet the minimum financial requirements necessary to
maintain its listing on the NASDAQ SmallCap Market.  Management has determined
that utilizing the capital to maintain this list is not in the best interest of
the shareholders, and chose not to raise the additional funds. Instead
management is focusing on raising funds to correct its current cost structure
and also improve its current financial position. Also, in order to achieve the
Company's plans for growth in the long distance business as well as its entry
into other communications services, the Company may require additional equity
and is currently seeking sources of funding.  The Company cannot give assurance
as to the potential success of these efforts.


Item 7A. Quantitative and Qualitative Disclosure About market Risk:

The Company does not invest in any derivative financial instruments, and all of
its cash is in commercial checking and money market accounts. The company has no
long-term debt. The Company uses its line of credit to finance a significant
portion of its operation. This on-balance sheet financial instrument, because of
its variable rate of interest, exposes the Company to interest rate risk
resulting from changes in the related banks' base rate. The Company does not
believe this risk to be material.

Item 8.  Financial Statements and Supplementary Data

See "Index To Consolidated Financial Statements and Notes To Consolidated
Financial Statements" on page F-i herein.

Item 9.  Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

Not applicable


                                       19
<PAGE>

                                   PART III
                                   ==== ===

Item 10.  Directors and Executive Officers of the Registrant

The following table sets forth information with respect to all of the directors
of the Company at March 3, 2001.

Name                  Age  Position                     Director Since
----                  ---  --------                     --------------

Dominic J. Romano    (60)  Director (1)                           1999

Walt Anderson        (47)  Director (2)                           1998

Murray Goldberg      (58)  Director (3)                           1996

Arthur Regan         (37)  Director and Secretary (4)             1997

James Rossi          (49)  Director and Chairman (5)              1999


(1)  Dominic J. Romano has been a Director of the Company since September 1999.
     Mr. Romano has served as the managing partner of Romano, Hearing & Testa, a
     certified public accounting and consulting firm located in Vineland, New
     Jersey, since 1967.  His areas of specialization include valuations of
     businesses for acquisition purposes and financial, tax and estate planning.
     He currently is a board member of Solar Communications Group, Inc.  He is a
     certified public accountant, registered municipal accountant, and he holds
     a Bachelor of Science in Accounting degree from Seton Hall University.

(2)  Walt Anderson has been a Director of the Company since May 1998.  Since
     1992, Mr. Anderson has been the financial advisor to Gold & Appel Transfer,
     S.A., a venture capital company, which owns substantial positions in
     several public and private telecommunications companies, including the
     Company.  Pursuant to a power of attorney, Mr. Anderson has sole investment
     power over the shares of Common Stock owned by Gold & Appel Transfer, S.A.
     Mr. Anderson is a pioneer in the telecommunications industry.  He founded
     Mid Atlantic Telecom, a regional long distance carrier, in 1984 to take
     advantage of the breakup of AT&T.  He also founded Espirit Telecom in 1991
     and was Chairman of that company until 1999.  Mr. Anderson is also on the
     Board of Directors of several other companies including TotalTel USA
     Communications, Net-tel Corp., World Exchange Communications, Teleport UK
     Ltd., American Technology Labs, Inc., Galactech Corp., Rotary Rocket Co,
     Aquarius Holdings Limited, and Cis Lunar Development.

(3)  Murray Goldberg has been a Director of the Company since November 1996 and
     an independent sales agent of the Company since 1993.  Mr. Goldberg is also
     the owner and a Vise-President of Jamco, Inc., a discount shoe distributor
     in Florida, and the owner and Director of Doxs, Inc., an anesthesia
     equipment developer and distributor.  From June 1994 until May 1996, he was
     also an owner of Strathmore Bagel Franchise Company.

(4)  Arthur Regan has been a Director of the Company since August 1997.  Mr.
     Regan has been President of Regan & Associates, Inc., a proxy
     solicitation/shareholder services firm in New York, New York that has been
     a vendor of the Company since 1993.  Since 1988, Mr. Regan has also been
     the Chairman, President and Chief Executive Officer of RD's Place, Inc., a
     messenger/courier company located in Jersey City, New Jersey.

(5)  James M. Rossi has been a Director of the Company since August 1999.  Mr.
     Rossi is a co-founder of Solar Communications Group, Inc., a productivity
     service provider, and has been a Director and Chairman and Chief Executive
     Officer of Solar Communications Group, Inc. since October 1994.  Mr. Rossi
     has also served as a Director and Chairman and Chief Executive Officer of
     JMR Corporation, a telecommunication consulting firm, since 1971, as a
     Director and Chairman and Chief Executive Officer of Cam-Comm, Inc. a data
     fiber optics reseller, since 1997, and as a President and a Director of
     Comanco, Inc., a data fiber optics reseller, since 1997.  Mr. Rossi
     resigned his position as Director and Chairman of the company on January
     18, 2001 without issues.


                                       20
<PAGE>

Executive Officers

The Company's executive officers are appointed by the Board of Directors and,
except as described below, hold office at the pleasure of the Board until their
successors are appointed and have qualified. During 2000, the Company had three
executive officers, David B. Hurwitz, Michael McAnulty and John Colarossi. Both
Messrs. McAnulty and Colarossi resigned from the Company in January 2001, when
it became evident to them that they would not survive the Startec Merger.

David B. Hurwitz, age 37, became the Executive Vice President of Sales and
Marketing and General Manager of the Company in December 1996 and was elected
President and Chief Executive Officer of the Company in February 1999.  From
1995 to 1996, he served as the Vice President of Sales and Marketing of
Commonwealth Long Distance, a company engaged in the provision of local and long
distance telephone services.  From 1993 to 1995, he served as Executive Vice
President and Chief Operating Officer of InterNet Communications Services, Inc.,
a company engaged in the provision of pre-paid calling card services.  From 1992
to 1995, he served as General Manager of FiberNet, a company engaged in the
provision of local and private line telephone services.  From 1985 to 1992 Mr.
Hurwitz held sales and sales management positions with RCI Long Distance, a
subsidiary of Rochester Telephone Corp. (now Frontier Corporation).

Randolph Fry, age 38, joined the Company in 1999 as the e-business development
manager and worked in the Company's Information Systems department until he was
named Chief Financial Officer in February 2001. Mr. Fry has a Masters Degree in
Finance from Drexel University, and a Bachelor's degree in Accounting from The
University of Tennessee. He has over 16 Years of experience in accounting,
finance and financial system analysis and development.

Section 16(a) - Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
officers, directors and persons who own more than ten percent (10%) of the
Common Stock to file reports of ownership and changes in ownership with the
Securities and Exchange Commission.  Officers, directors and greater than ten
percent (10%) shareholders are required by regulations to furnish the Company
with copies of all Section 16(a) forms they file.  Based solely on review of the
copies of such forms furnished to the Company or a written representation that
no Annual Statements of Beneficial Ownership of Securities on Form 5 were
required to be filed, the Company believes that during the year ended December
31, 2000, all Section 16(a) filing requirements applicable to its officers,
directors and greater than ten percent (10%) shareholders were complied with.


Item 11.  Executive Compensation and Options Outstanding

The following table sets forth certain information concerning the compensation
paid for the years ended December 31, 2000, 1999 and 1998:  (i) to the Company's
President and Chief Executive Officer, and (ii) to the Company's former
President and Chief Executive Officer.  The combined 2000 salary and bonus of
the Company's other executive officers, Michael McAnulty and John Colarossi were
$116,636 and $160,500 respectively.  Both Mr. McAnulty and Mr. Colarossi
resigned from the Company in January 2001.


                                       21
<PAGE>

                          SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>

                                                   Long Term Compensation
               Annual Compensation                         Awards
---------------------------------------------------------------------------------
Name                                                       Common            All
And                                                         Stock           Other
Principal                        Salary    Bonus         Underlying         Comp.
Position                  Year    ($)       ($)          Options (#)         ($)
---------------------------------------------------------------------------------
<S>                       <C>   <C>       <C>           <C>                <C>
David B. Hurwitz           `00  225,000   77,069                500           --
President and Chief        `99  217,578       --            400,000           --
 Executive Officer (1)     `98  215,030       --             50,000           --
---------------------------------------------------------------------------------
John Colarossi             `00  120,000   40,500                 --           --
---------------------------------------------------------------------------------
Michael McAnulty           `00   96,637   20,000                 --           --
---------------------------------------------------------------------------------
</TABLE>

(1)  Mr. Hurwitz became President and Chief Executive Officer on February 17,
     1999.

Option Grants In Last Fiscal Year

The following table summarizes the number of options granted to the named
executive officers during the year ended December 31, 2000.  The Company did not
grant any stock appreciation rights in 2000.

<TABLE>
<CAPTION>
                                                                                                    Potential Realizable
                                                                                                      Value of Assumed
                        Number of Shares of      Percent of Total                                    Annual Rates of Stock
     Name                 Common Stock            Options Granted    Exercise       Expiration      Price Appreciation for
                        Underlying Options        in Fiscal Year(1)    Price           Date             Option Term(2)
                             Granted
<S>                     <C>                      <C>                 <C>           <C>              <C>         <C>
---------------------------------------------------------------------------------------------------------------------------------
                                                                                                           5%     10%
---------------------------------------------------------------------------------------------------------------------------------
David B. Hurwitz               500                       0.2%           $1.25         05/01/03            $100   $340
---------------------------------------------------------------------------------------------------------------------------------
John Colarossi                 500                       0.2%           $1.25         05/01/03            $100   $340
---------------------------------------------------------------------------------------------------------------------------------
Michael McAnulty               500                       0.2%           $1.25         05/01/03            $100   $340
---------------------------------------------------------------------------------------------------------------------------------
</TABLE>


(1) Based upon options to purchase a total of 224,500 shares granted to all
    officers and employees of the Company in 2000 under its Amended and Restated
    Stock Option Plan or its predecessor plans.

(2) These amounts represent hypothetical gains that could be achieved for the
    respective stock options if exercised at the end of the option term.  These
    gains are based on assumed rates of stock appreciation of 5% and 10%
    compounded annually from the date the respective options were granted to
    their expiration date.


                                       22
<PAGE>

Aggregated Option Exercises In Last Fiscal Year and Fiscal Year-end Option
Values

The following table summarizes the number and value of unexercised options held
by the named officers as of December 31, 3000.

<TABLE>
<CAPTION>


                                Number of         Value                 Number of
                                  Shares        Realized                Shares of                           Value of
                               Acquired on                            Common Stock                        Unexercised
                                 Exercise                              Underlying                         In-The-Money
                                                                       Unexercised                          Options
                                                                         Options                          or Warrants
                                                                     or Warrants at                        at Fiscal
                                                                     Fiscal Year-End                      Year-End(1)
                                                              ===============================   ================================
NAME                                                          EXERCISABLE #   UNEXERCISABLE #   EXERCISABLE $    UNEXERCISABLE $
================================================================================================================================
<S>                           <C>             <C>            <C>              <C>              <C>               <C>
David B. Hurwitz                          --             --        1,100,000              500                $0               $0
--------------------------------------------------------------------------------------------------------------------------------
John Colarossi                            --             --           90,500           20,500                $0               $0
--------------------------------------------------------------------------------------------------------------------------------
Michael McAnulty                          --             --           65,000                0                $0               $0
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>


(1) Based upon a market price of the Company's common stock on December 1, 2000
    of $.1875 per share, the price of the stock at the date  (last trading day
    in December 2000).


Compensation of Directors

Directors who also serve as salaried employees of the Company do not receive any
additional compensation for their services as directors.

In 2000, non-employee directors are entitled to receive $1,000 for each Board
meeting attended in person, and $500 for participation in each Board meeting
conducted by telephone conference call


Employment Agreements

There are no current employment agreements with senior management.

Item 12.  Security Ownership of Certain Beneficial Owners and Management
------------------------------------------------------------------------

The following table sets forth, as of March 14, 2000, information concerning the
shares of the Company's Common Stock beneficially owned by: (a) each person or
group known to the Company to be the beneficial owner of more than 5% of the
outstanding shares of Common Stock; (b) each director and named executive
officer; and (c) all directors and executive officers as a group.  Except as
otherwise indicated below, to the Company's knowledge, each person named or
included in a group has sole voting and investment power with respect to his or
its shares of Common Stock.


Name and Address of Beneficial        Amount and Nature
Owner or Identity of Group         of Beneficial Ownership   Percent of Class
---------------------------------  ------------------------  -----------------

James M. Rossi                                     152,000                  *
21 East Main Street
Suite 201
Millville, NJ 08332

Dominic J. Romano                                  100,000(1)               *
150 South Main Road
Vineland, NJ 08360

Murray Goldberg                                    285,183(2)             1.2%
26 Anthony Drive
Malvern, PA 19355

Arthur Regan                                        57,000(3)               *




                                       23
<PAGE>

15 Park Row
New York, NY  10038

Walter Anderson
c/o Gold & Appel Transfer, S.A.               17,657,734(4)(5)(8)        71.4%
Omar Hodge Building
Wickhams Cay
Road Town
Tortula, British Virgin Islands

David B. Hurwitz                               1,111,500(6)               4.5%
2 Greenwood Square
3331 Street Road
Suite 275
Bensalem, PA 19020

Randolph A. Fry                                   15,500(7)                 *
2 Greenwood Square

3331 Street Road
Suite 275
Bensalem, PA 19020

All Directors and Executive Officers
as a group                                    19,378,917                 78.3%
(7  persons)
---------------------
*  Less than 1%

(1)  Consists of 100,000 shares of Common Stock at $1.5625 per share.

(2)  Consists of 260,183 shares of Common Stock owned by Mr. Goldberg as well as
     options to purchase 25,000 shares of Common Stock at $1.1875 per share.

(3)  Consists of 12,000 shares of Common Stock owned by Mr. Regan, options to
     purchase 25,000 shares of Common Stock at $1.1875 per share and options to
     purchase 20,000 shares of Common Stock at $1.69 per share.

(4)  All of such shares are held of record by Gold & Appel Transfer, S.A.
     Pursuant to a power of attorney, Mr. Anderson has sole investment power
     over such shares and as a result may be deemed to be the beneficial owner
     of such shares.  Mr. Anderson, however, has disclaimed such beneficial
     ownership.  Excludes 2,186,433 shares of Common Stock held by the
     Foundation for the International Non-Governmental Development of Space, a
     non-profit organization ("FINDS"), of which Mr. Anderson is the president
     and director.  Mr. Anderson has no pecuniary interest in the shares held by
     FINDS and has no power to control the voting or disposition of the shares
     held by FINDS.  Mr. Anderson has disclaimed beneficial ownership of such
     shares.  The information in this note (4) is based on a joint Schedule
     13D/A dated April 2, 2001 filed by Gold & Appel Transfer, S.A. and Mr.
     Anderson with the Securities and Exchange Commission.

(5)  Based on a joint Schedule 13D/A dated April 2, 2001 filed Gold & Appel
     Transfer, S.A. and Mr. Anderson with the Securities and Exchange
     Commission.

(6)  Consists of 1,161,000 shares of Common Stock owned by Mr. Hurwitz as well
     as options to purchase 350,000 shares of Common Stock at $1.03125 per
     share, options to purchase 300,000 shares of Common Stock at $1.30 per
     share and options to purchase 50,000 shares of Common Stock at $1.1875 per
     share and options to purchase 400,000 shares of Common Stock at $1.5625 per
     share. Does not include options to purchase 500 shares of Common Stock at
     $1.25 per share, which options do not first become exercisable until May 1,
     2001.

(7)  Consists of 10,000 shares of Common Stock at $1.75 per share and options to
     purchase 5,000 shares of Common Stock at $1.625 per share.  Does not
     include options to purchase 500 shares of Common Stock at $1.25 per share,
     which options do not first become exercisable until May 1, 2001.



                                       24
<PAGE>

(8)  On March 28, 2001 Gold and Appel, S.A. sold its controlling interest in the
     Company, or 15,471,301 shares, to Henry Luken III at a price of $.20 per
     share for a total of $3,094,260.

Item 13.  Certain Relationships and Related Transactions

Indemnification Arrangements

The Company is party to indemnification agreements with two of its directors,
Aaron R. Brown and Stephen J. Parker, dated August 1990.  In addition, the
Company has entered into an indemnification agreement with Kevin O'Hare, a
former executive officer of the Company, dated July, 1997.  In general, the
indemnification agreements obligate the Company to indemnify each of Messrs.
Brown, Parker and O'Hare against the liabilities and expenses incurred by them
in acting as a director or officer of the Company to the maximum extent allowed
by law.  As stated above, the Company, together with Messrs. Parker, Brown and
O'Hare, have been sued by a former president for various claims asserted by the
plaintiff in connection with his termination of employment with the Company on
December 30, 1996.  The Company and the individual defendants have selected
counsel to defend the action.  The Board of Directors has authorized the Company
to advance the expenses of the individual defendants incurred in defending this
action upon the receipt of an undertaking from each of them to repay the amounts
so advanced in the event it is determined that they are not entitled to
indemnification under applicable law.  As of December 31, 2000, no amounts had
been advanced by the Company under such agreements. As a result of the
settlement with the Company's former president, Messrs. Brown, Parker and O'Hare
have been release from all liability regarding the litigation brought forth as
referenced to above.

Sales Agency

Mr. Goldberg acts as a sub-agent for the Company and is the co-owner of Goldberg
& Associates, a company that acts as an agent for the Company in the sale of the
Company's products and services.  During 2000, the Company paid Mr. Goldberg and
such company a total of $42,961 in commissions for their services as the
Company's sales agents.  Commissions paid to Mr. Goldberg and such company were
at competitive rates.

Private Placement

On May 19, 2000, the Company through a private placement transaction, issued
666,667 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, in full payment of a loan obligation with an
original principal amount of $1,000,000.  The terms of such transaction were
negotiated between the Company and Gold & Appel Transfer, S.A. on an arms length
basis, with Mr. Anderson, the controlling party of Gold & Appel, abstaining from
all negotiations.

On May 19, 2000, the Company the Company through a private placement
transaction, issued 333,333 shares of common stock to the Foundation for the
International Non-Governmental Development of Space, a non-profit organization
("FINDS"), of which Mr. Anderson is the president and director, in full payment
of a loan obligation with an original principal amount of $500,000.  The terms
of such transaction were negotiated between the Company and Gold & Appel
Transfer, S.A. on an arms length basis, with Mr. Anderson, the president and a
director of FINDS, abstaining from all negotiations.

On June 30, 2000 the Company through a private placement transaction, issued
720,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $900,000 or $1.25
per share.  The proceeds of the issuance are being used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

Acquisitions

On March 17, 2000, the Company purchased certain assets of the business of Cam-
Comm, Inc. At the time of the transaction, James Rossi was the chairman of the
Company and owned Cam-Comm. The Company acquired the customer base and accounts
receivable of $83,876 private line customers from Cam-Comm, Inc. in exchange for
a cash payment of $150,000 and an agreement to pay an amount of $76,405 for an
outstanding liability of Cam-Comm, Inc. Goodwill of $142,529 was recorded and
will be amortized over three years.



                                       25
<PAGE>

                                    PART IV
                                    ==== ==


Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K
-------------------------------------------------------------------------

(a)  Documents filed as part of this Annual Report on Form 10-K:

     (1)  Financial Statements
          --------------------

          See "Index To Consolidated Financial Statements and Financial
          Statement Schedules" on page F-i herein.


     (2)  Financial Statement Schedules required to be filed by Item 8 on this
          --------------------------------------------------------------------
form.
-----

          See "Index To Consolidated Financial Statements and Financial
          Statement Schedules" on page F-i herein.


(b)  Reports on Form 8-K:

     1.  On November 2, 2000, Capsule Communications, Inc. (the "Company")
         entered into an Agreement and Plan of Reorganization(the "Merger
         Agreement") with Startec Global Communications Corporation, a Delaware
         corporation ("Startec"),a wholly-owned subsidiary of Startec, Stars
         Acquisition Corp., a Delaware corporation ("Stars"), Gold & Appel
         Transfer, S.A. ("Gold & Appel")and Foundation for the International
         Non-Governmental Development of Space ("FINDS"). Pursuant to the Merger
         Agreement and subject to the conditions set forth in the Merger
         Agreement (including approval of the Merger Agreement by the
         stockholders of each of the Company and Startec, receipt of required
         regulatory approvals, effectiveness of a registration statement
         registering the shares of Startec common stock to be issued in the
         Merger and other customary closing conditions) Stars will merge with
         and into the Company. The Company, the surviving corporation, will
         become a wholly-owned subsidiary of Startec.

     2.  On January 18, 2001, James M. Rossi tendered his resignation as
         Chairman of the board of directors of Capsule Communications, Inc.
         effective immediately.

     3.  Effective January 23, 2001, Capsule Communications, Inc. (the
         "Company") terminated its previously announced merger agreement with
         Startec Global Communications Corp.

     4.  On March 30, 2001, the Board of Directors of Capsule Communications,
         Inc. (the "Company") unanimously approved the appointment of Walt
         Anderson as the Chairman of the Board, effective immediately. A copy of
         the Company's press release is attached hereto as Exhibit 99.1 and is
         incorporated herein by reference.

(c)  Exhibits

Exhibit No.  Description
-----------  -----------

   2.1       Agreement and Plan of Merger with Capsule Communications, Inc.(1)
   2.2       Certificate of Incorporation with Capsule Communications, Inc.(1)
   2.3       By-Laws of Capsule Communications, Inc.(1)
   3.1       Certificate of Incorporation of Registrant(2)
   3.2       Amendment to Certificate of Incorporation(2)
   3.3       By-Laws of Registrant(2)
   3.4       Amended and Restated By-Laws of the Company********
   4.1       Specimen Common Share Certificate(2)
  10.1       DSC Marketing Services Supply Agreement(3)
  10.2       Key Employees Incentive Stock Option Plan(3)



                                       26
<PAGE>

  10.3      Employee Compensation Stock Option Plan(3)
  10.4      Loan and Security Agreement between US Wats, Inc. and Century
            Business Credit Corporation dated May 11, 1995(4)
  10.5      Severance, General Release, and Cooperation Agreement dated
            August 21, 1999, between US Wats, Inc. and Stephen Parker(5)
  10.6      Stock Repurchase Agreement dated August 21, 1999, between US Wats,
            Inc. and Stephen Parker(8)
  10.7      Agreement of Lease for 3 Parkway, Philadelphia, PA(3)
  10.8      Employment Agreement dated December 13, 1999, between US Wats, Inc.
            and David B. Hurwitz*(5)
  10.9      Employment Agreement dated January 15, 2000, between US Wats, Inc.
            and Michael McAnulty*(5)
 10.10      Employment Agreement dated January 15, 2000, between US Wats, Inc.
            and John Colarossi*(5)
 10.11      Purchase Agreement dated March 17, 2000, between US Wats, Inc. and
            Cam-Comm, Inc.(5)
 10.12      Loan Agreement dated March 22, 2000, between US Wats, Inc. and Gold
            & Appel Transfer, S.A.(5)
 10.13      Loan Agreement dated March 22, 2000, between US Wats, Inc. and
            Foundation for the International Non-governmental Development of
            Space(5)
 10.14      Stock Option and Consulting Agreement dated December 13, 1999,
            between US Wats, Inc. and Dominic Romano*(6)
 10.15      Amendment and extension of the Loan and Security Agreement between
            Capsule Communications, Inc. and Wells Fargo Business Credit Credit
            Corporation dated June 21, 2000.
 10.16      Agreement of Lease for 3331 Street Road Parkway, Bensalem, PA
 10.17      Agreement of Lease for 401 N. Broad Street, Philadelphia, PA
 10.18      Agreement of Lease for 180 Grand Ave., Oakland, CA
 10.19      Loan Agreement dated May 19, 2000, between Capsule Communications,
            Inc. and Gold & Appel Transfer, S.A. and Foundation for the
            International Non-governmental Development of Space.
 10.20      Loan Agreement dated June 30, 2000, between Capsule Communications,
            Inc. and Gold & Appel Transfer, S.A. and Foundation for the
            International Non-governmental Development of Space
 10.21      Loan Agreement dated March 15, 2001, between Capsule Communications,
            Inc. and Gold & Appel Transfer, S.A. and Foundation for the
            International Non-governmental Development of Space
 10.22      Stock Option Agreement dated May 1, 2000, between Capsule
            Communications, Inc. and David B. Hurwitz*
 10.23      Stock Option Agreement dated May 1, 2000, between Capsule
            Communications, Inc. and Michael McAnulty*
 10.24      Stock Option Agreement dated May 1, 2000, between Capsule
            Communications, Inc. and John Colarossi*
 10.25      Proposed merger agreement with Startec Global Communications,
            Inc.(7)
 10.26      Consent of Deloitte and Touche, LLP

(1)  Incorporated by reference to the October 25, 1999 Form DEF 14A
(2)  Filed as an exhibit with corresponding Exhibit No. to Registrant's post
     effective amendment No. 1 to Registration Statement on Form S-18, or
     previous Annual Report Form 10-K.
(3)  Incorporated by reference to the December 31, 1992 Form 10-K
(4)  Incorporated by reference to the June 30, 1995 Form 10-Q
(5)  Incorporated by reference to the December 31, 1999 Form 10-K
(6)  Incorporated by reference to the September 16, 1999 Form 8-K
(7)  Incorporated by reference to the November 2, 2000 Form 8-K
(8)  Incorporated by reference to the September 1, 1998 Form 8-K


*  Compensatory arrangement



                                       27
<PAGE>

                                   SIGNATURES


Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.



                         Capsule Communications, Inc.
                         (Registrant)

                         By:    /s/  Randolph A. Fry
                               ---------------------
                               Randolph A. Fry
                               Chief Financial Officer

                         Date:  April 12, 2001


Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.



SIGNATURE                 TITLE                                  DATE
---------                 -----                                  ----


/s/  David B. Hurwitz     President and Chief Executive Officer  April 12,2001
------------------------
David B. Hurwitz

/s/  Randolph A. Fry      Chief Financial Officer                April 12,2001
------------------------
Randolph A. Fry

/s/  Walt Anderson        Chairman of the Board                  April 12,2001
------------------------
Walt Anderson

/s/  Dominic J. Romano    Director                               April 12,2001
------------------------
Dominic J. Romano





                                       28
<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.)  AND SUBSIDIARIES
                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
                 YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998


                                                                      Page (s)
                                                                      --------

CONSOLIDATED FINANCIAL STATEMENTS:

Independent Auditors' Report                                            F-1

Consolidated Balance Sheets
     December 31, 2000 and 1999                                      F-2 to F-3

Consolidated Statements of Operations
     Years ended December 31, 2000, 1999, and 1998                      F-4

Consolidated Statements of Common Shareholders' Equity (Deficiency)
     Years ended December 31, 2000, 1999, and 1998                   F-5 to F-7

Consolidated Statements of Cash Flows
     Years ended December 31, 2000, 1999, and 1998                      F-8


Notes to Consolidated Financial Statements                          F-9 to F-22

Financial Statement Schedule
- Schedule II - - Valuation and Qualifying Accounts                     F-23

                                      F-i
<PAGE>

INDEPENDENT AUDITORS' REPORT
Board of Directors and Shareholders
Capsule Communications, Inc.
Bensalem, Pennsylvania

We have audited the accompanying consolidated balance sheets of Capsule
Communications, Inc. (formerly US Wats, Inc.) and subsidiaries (the "Company")
as of December 31, 2000 and 1999, and the related consolidated statements of
operations, common shareholders' equity (deficiency), and cash flows for each of
the three years in the period ended December 31, 2000. Our audits also included
the financial statement schedule listed in the Index at Item 14(a)(2). These
financial statements and financial statement schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America.  Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements.  An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation.  We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company and subsidiaries as of
December 31, 2000 and 1999, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2000, in
conformity with accounting principles generally accepted in the United States of
America. Also in our opinion, such financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.

The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern.  As discussed in Note 3 to
the consolidated financial statements, the Company's recurring net losses,
negative working capital, financing requirements and negative cash flows from
operations raise substantial doubt about its ability to continue as a going
concern. Management's plans concerning these matters are also described in
Note 3. The consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.




DELOITTE & TOUCHE LLP
Philadelphia, Pennsylvania

March 30, 2001




                                      F-1
<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS



                                                        December 31,
                                                ------------------------
ASSETS                                              2000        1999
------                                          ------------ -----------
Current Assets
 Cash and cash equivalents                        $1,569,473  $  827,048
 Restricted cash                                     823,571     770,363
 Accounts receivable, net of allowance for
  doubtful accounts of $1,188,238 for 2000 and
  $1,711,853 for 1999                              5,850,739   5,772,799
 Prepaid expenses and other                           53,938     201,724
                                                ------------ -----------

   Total Current Assets                            8,297,721   7,571,934
                                                ------------ -----------

Property and Equipment
 Telecommunications equipment                      4,255,311   4,120,775
 Equipment                                         1,973,382   1,863,177
 Software                                            655,422     655,422
 Office furniture and fixtures                       163,882     161,282
 Leasehold improvements                              675,765     668,820
                                                ------------ -----------
                                                   7,723,762   7,469,476
Less accumulated depreciation and amortization     5,201,253   4,459,111
                                                ------------ -----------

 Total Property and Equipment, net                 2,522,509   3,010,365
                                                ------------ -----------

Other assets, net                                    338,216     323,914
                                                ------------ -----------

       Total                                     $11,158,446 $10,906,213
                                                ============ ===========




                                      F-2


  The accompanying notes are an integral part of these consolidated financial
                                  statements

<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS


                                                            December 31,
                                                    ---------------------------
                                                        2000          1999
                                                    ------------   ------------
Liabilities and Shareholders' Equity (Deficit)
----------------------------------------------
Current Liabilities
 Note payable                                       $  1,858,673   $  1,036,507
 Capital lease obligations, current portion                   --        153,289
 Accounts payable and accrued carrier cost             5,753,606      5,085,368
 Accrued commissions                                     637,483        643,321
 Accrued expenses and other                            1,743,747      1,162,975
 State and Federal taxes payable                       1,184,708      1,039,966
 Deferred revenue                                        176,129              -
                                                    ------------   ------------

  Total Current Liabilities                           11,354,346      9,121,426
                                                    ------------   ------------

Commitments and Contingencies - see note 7

Common Shareholders' Equity (Deficit)
 Common stock, $.001 par, authorized
  100,000,000 shares; issued:
  22,667,444 shares in 2000 and
  20,814,944 shares in 1999                               22,668         20,926
 Additional paid-in capital                           14,868,673     12,087,332
 Accumulated deficit                                 (15,087,022)   (10,323,252)
                                                    ------------   ------------
                                                        (195,681)     1,785,006
 Common stock held in treasury
 (219,000 shares in 2000 and 1999), at par value            (219)          (219)
                                                    ------------   ------------

                                                        (195,900)     1,784,787
                                                    ------------   ------------

   Total                                            $ 11,158,446   $ 10,906,213
                                                    ============   ============







                                      F-3

  The accompanying notes are an integral part of these consolidated financial
                                  statements
<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>


                                                         Years Ended December 31,
                                                 -----------------------------------------
                                                     2000          1999           1998
                                                 -----------    -----------    -----------
<S>                                             <C>            <C>            <C>
Revenues                                         $37,368,359    $39,777,331    $44,679,060

Cost of sales                                     27,228,782     28,195,547     31,789,200
                                                 -----------    -----------    -----------

Gross profit                                      10,139,577     11,581,784     12,889,860

Selling, general and administrative expenses      13,950,198     13,038,455     13,851,001

Provision for bad debts                              714,921      1,453,496        788,493
                                                 -----------    -----------    -----------

Loss from operations                              (4,525,542)    (2,910,167)    (1,749,634)

Other income (expense)
 Interest income                                     141,841        135,646        164,180
 Interest expense                                   (380,069)      (181,197)      (232,915)
                                                 -----------    -----------    -----------

Loss before income taxes                          (4,763,770)    (2,955,718)    (1,818,369)

Income tax benefits (expense)                             --          4,819        (10,000)
                                                 -----------    -----------    -----------

Net loss                                          (4,763,770)    (2,950,899)    (1,828,369)

Preferred dividends and accretion                         --         13,500         27,000
                                                 -----------    -----------    -----------

Net loss attributable to
 common shareholders                             $(4,763,770)   $(2,964,399)   $(1,855,369)
                                                 ===========    ===========    ===========

Net loss per share
 attributable to common shareholders             $      (.22)   $      (.15)   $      (.10)
                                                 ===========    ===========    ===========

Weighted average number of shares outstanding     21,694,726     20,009,728     18,785,656
                                                 ===========    ===========    ===========

</TABLE>

                                      F-4


  The accompanying notes are an integral part of these consolidated financial
                                  statements
<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
      CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY (DEFICIENCY)
                         YEAR ENDED DECEMBER 31, 2000

<TABLE>
<CAPTION>

                                                Common    Common   Additional                    Treasury  Treasury
                                Common Stock   Par Value  Stock    Paid-In                       Stock     Stock At    Shareholders'
Description                     Shares Issued   $  .001   Payable  Capital         Deficit       Shares    Par Value   Equity
------------------------------  -------------  ---------  -------  ------------  -------------   --------  ---------   ------------
<S>                             <C>            <C>        <C>      <C>           <C>             <C>       <C>         <C>
Balance, December 31, 1999         20,925,944    $20,926       $0   $12,087,332   $(10,323,252)   219,000      $(219)   $ 1,784,787
Net Loss                                                                            (4,763,770)                          (4,763,770)

Exercise of Employee Stock             21,500         22                 26,504                                              26.526
    Options
Conversion of note payable          1,000,000      1,000              1,499,000                                           1,500,000
Private Placement                     720,000        720                899,280                                             900,000
Options Issued to Employees at                                          141,340                                             141,340
    Below Market Value

Beneficial conversion of
 feature relating to
 debt issuance.                                                         215,217                                             215,217
                                -------------  ---------  -------  ------------  -------------   --------  ---------   ------------
Balance, December 31, 2000         22,667,444    $22,668       $0   $14,868,673   $(15,087,022)   219,000      $(219)  $   (195,900)
                                =============  =========  =======  ============  =============   ========  =========   ============
</TABLE>


                                      F-5

  The accompanying notes are an integral part of these consolidated financial
                                  statements

<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
      CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY (DEFICIENCY)
                          YEAR ENDED DECEMBER 31, 1999

<TABLE>

                                               Common     Common   Additional                    Treasury    Treasury
                                Common Stock   Par Value  Stock    Paid-In                       Stock       Stock At
Description                     Shares Issued   $  .001   Payable  Capital       Deficit         Shares      Par Value
------------------------------  -------------  ---------  -------  ------------  -------------   ---------   ---------
<S>                             <C>            <C>        <C>      <C>           <C>             <C>         <C>
Balance, December 31, 1998         20,077,144    $20,077            $ 9,514,075   $ (7,358,853)  1,119,000     $(1,119)
Net Loss                                                                            (2,950,899)
Shares Issued in Acquisition          150,000        150                262,350
Exercise of Employee Stock            398,800        399                420,896
    Options
Conversion of Preferred Stock         300,000        300                329,700
Private Placement                                                     1,529,100                   (900,000)        900
Options Issued to Employees at                                           31,211
     Below Market Value
Cash Dividends on Preferred
    Stock ($.90 per share)                                                             (13,500)
                                -------------  ---------  -------  ------------  -------------   ---------   ---------
Balance, December 31, 1999         20,925,944    $20,926       $0   $12,087,332   $(10,323,252)    219,000     $  (219)
                                 ============  =========  =======  ============  =============   =========   =========
<CAPTION>

                                 Shareholders'
Description                      Equity
------------------------------   -------------
<S>                              <C>
Balance, December 31, 1998         $ 2,174,180
Net Loss                            (2,950,899)
Shares Issued in Acquisition           262,500
Exercise of Employee Stock             421,295
    Options
Conversion of Preferred Stock          330,000
Private Placement                    1,530,000
Options Issued to Employees at          31,211
     Below Market Value
Cash Dividends on Preferred
    Stock ($.90 per share)             (13,500)
                                 -------------
Balance, December 31, 1999         $ 1,784,787
                                 =============

</TABLE>
                                      F-6

  The accompanying notes are an integral part of these consolidated financial
                                  statements

<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
      CONSOLIDATED STATEMENTS OF COMMON SHAREHOLDERS' EQUITY (DEFICIENCY)
                         YEAR ENDED DECEMBER 31, 1998

<TABLE>
<CAPTION>

                                               Common     Common    Additional                   Treasury   Treasury
                                Common Stock   Par Value  Stock     Paid-In                      Stock      Stock At
Description                     Shares Issued    $  .001  Payable   Capital       Deficit        Shares     Par Value
------------------------------  -------------  ---------  -------   -----------   ------------   ---------  ---------
<S>                             <C>            <C>        <C>       <C>           <C>            <C>        <C>
Balance, December 31, 1997         17,654,100    $17,654    $ 166   $ 5,328,982    $(5,503,484)    250,000    $  (250)
Net Loss                                                                            (1,828,369)

Short-Swing Profit Proceeds                                           2,430,979

Exercise of Employee Stock          1,068,984      1,069              1,403,422
    Options

Exercise of Warrants                1,188,000      1,188              1,259,419

Common Stock Issued                   166,060        166    $(166)

Options Issued for Consulting                                           133,204
    Services

Repurchase of Common Stock                                           (1,041,931)                   869,000    $  (869)

Cash Dividends on Preferred
    Stock ($.90 per share)                                                             (27,000)
                                -------------    -------  -------   -----------   ------------   ---------  ---------
Balance, December 31, 1998         20,077,144    $20,077    $   0   $ 9,514,075    $(7,358,853)  1,119,000    $(1,119)
                                =============    =======  =======   ===========   ============   =========  =========
<CAPTION>


                                 Shareholders'
                                 Equity
Description                      (Deficiency)
------------------------------   -------------
<S>                              <C>
Balance, December 31, 1997         $  (156,932)
Net Loss                            (1,828,369)

Short-Swing Profit Proceeds          2,430,979

Exercise of Employee Stock           1,404,491
    Options

Exercise of Warrants                 1,260,607

Common Stock Issued

Options Issued for Consulting          133,204
    Services

Repurchase of Common Stock          (1,042,800)

Cash Dividends on Preferred
    Stock ($.90 per share)             (27,000)
                                 -------------
Balance, December 31, 1998         $ 2,174,180
                                   ===========

</TABLE>

                                      F-7

  The accompanying notes are an integral part of these consolidated financial
                                  statements
<PAGE>

CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOW
<TABLE>
<CAPTION>

                                                                               Years Ended December 31,
                                                                       ---------------------------------------
                                                                           2000          1999          1998
                                                                       -----------   -----------   -----------
<S>                                                                   <C>            <C>           <C>
OPERATING ACTIVITIES:
      Net loss before preferred dividends                              $(4,763,770)  $(2,950,899)  $(1,828,369)
      Adjustment to reconcile net loss to
      net cash provided by (used-in) operating activities
           Beneficial conversion feature relating to debt issuance         215,217            --            --
           Stock and stock options issued for service                           --        31,211       133,204
           Stock based compensation                                        141,340            --            --
           Depreciation and amortization                                 1,008,046     1,069,329     1,439,171
           Provision for bad debts                                         714,921     1,453,496       788,493
      Changes in assets and liabilities which provided
       (used) cash:
           Accounts receivable                                            (792,861)   (1,060,399)      (55,307)
           Prepaid expenses and other                                      147,786       (34,747)      (58,294)
           Other assets                                                   (144,455)       54,356        (8,272)
           Accounts payable and accrued expenses                         1,243,173       837,099    (2,872,750)
           Deferred revenue                                                176,129        (2,887)      (72,607)
           State & Federal Taxes payable                                   144,742        78,235      (331,686)
                                                                       -----------   -----------   -----------

      Net cash used in operating activities                             (1,909,732)     (525,206)   (2,866,417)
                                                                       -----------   -----------   -----------

INVESTING ACTIVITIES:
      Purchase of property and equipment                                  (418,307)   (1,172,358)   (1,276,562)
      Disposal of equipment                                                 28,269            --            --
      Investment in Internet service provider                                   --            --        40,000
      Increase in restricted cash                                          (53,208)     (770,363)           --
                                                                       -----------   -----------   -----------

      Net cash used in investing activities                               (443,246)   (1,942,721)   (1,236,562)
                                                                       -----------   -----------   -----------

FINANCING ACTIVITIES:
      Proceeds from issuance of convertible debt                         1,500,000            --            --
      Proceeds from private placement                                      900,000     1,530,000            --
      Proceeds from stock option and warrant exercises                      26,526       421,295     2,665,098
      Short swing profit proceeds                                               --            --     2,430,979
      Buyback of common stock                                                   --            --    (1,042,800)
     (Decrease) increase in notes payable net                              822,166       (84,834)      430,515
      Repayment of capital lease obligations                              (153,289)     (223,471)     (276,595)
      Preferred stock dividends                                                 --       (13,500)      (27,000)
                                                                       -----------   -----------   -----------

      Net cash provided by financing activities                          3,095,403     1,629,490     4,180,197
                                                                       -----------   -----------   -----------

Net increase (decrease) in cash                                            742,425      (838,437)       77,218

Beginning cash and cash equivalents                                        827,048     1,665,485     1,588,267
                                                                       -----------   -----------   -----------

Ending cash and cash equivalents                                       $ 1,569,473   $   827,048   $ 1,665,485
                                                                       ===========   ===========   ===========

</TABLE>
                                      F-8

  The accompanying notes are an integral part of these consolidated financial
                                   statements


<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  Background

Capsule Communications, Inc. (the "Company" or "CAPS") formerly U.S. Wats, Inc.
is a switch-based interexchange carrier providing long distance telephone
communications services primarily to small and medium-size business customers as
well as residents. The Company also provides inbound-800 long distance services,
as well as other telecommunications services such as travel cards (calling
cards),local service, cellular, paging, Internet service, dedicated access, data
services, pre-paid calling cards (debit cards), international callback, and
carrier termination services. The Company uses its own switches and facilities
to originate, transport and terminate calls for customers generally located in
the Mid-Atlantic region and California (on-net areas). For calls originating or
terminating outside the Company's own network (off-net area), the Company
utilizes the services provided by other long distance companies. Substantially
all of the Company's revenues are earned from its customers located on the East
Coast.

On May 3, 2000, the Company reincorporated in the State of Delaware as Capsule
Communications, Inc.  The Company was formerly known as US WATS, Inc.  As part
of this reincorporating merger, the Company increased the number of authorized
shares of common stock of the Company from 30,000,000 to 100,000,000 and the
number of authorized shares of preferred stock of the Company from 1,000,000 to
2,000,000.

2.  Summary Of Significant Accounting  Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and
its four wholly-owned subsidiaries, USW Corporation, USW Enterprises, Inc.,
Carriers Group, Inc. and US Wats of Virginia Inc. after elimination of all
inter-company accounts, transactions and profits.

Business Segments

The Company's operations have been aggregated into a single reportable segment,
based on the similarity of its customer, products and methods of distribution,
as permitted under SFAS No. 131.

Revenue Recognition

The Company recognizes revenue based upon the customer's usage of services. The
Company bills its customers for service on a monthly basis.  However, in some
instances, it bills certain customers on a more frequent basis.

Cash and Cash Equivalents

The Company considers cash in bank and repurchase agreements with a maturity of
three months or less when purchased as cash and cash equivalents.

At certain times during the year, the Company has balances in its operating
accounts that in the aggregate exceed the $100,000 Federal Deposit Insurance
Corporation insurance limit.





                                      F-9
<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Property and Equipment

Property and equipment are recorded at cost. Depreciation is calculated for
financial reporting purposes using the straight-line method over the estimated
useful lives of the assets:

          Telecommunications equipment ......................7 years
          Furniture fixtures and other.......................5 years

Depreciation and amortization expense of property, plant and equipment, loan
origination costs and goodwill for 2000, 1999, and 1998, was $1,008,046,
$1,069,329, and $1,439,171, respectively.

Deferred Financing Costs

Loan origination costs are amortized over the term of the related loan, and are
included in other assets.

Goodwill

The Company records the excess of purchase price over the fair market value of
net assets acquired as goodwill.  Goodwill is amortized using the straight line
method over 3 years.

Accounts Payable

Accounts payable includes the cost of access charges due local telephone
companies and long distance transport purchased from long distance carriers.

Marketing

All costs related to marketing and advertising the Company's products and
services are expensed in the period incurred.

Use of Estimates

The preparation of the Consolidated Financial Statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period.  Actual results could differ from those estimates.

Income Taxes

The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." (See Note 6)









                                      F-10
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Loss per Common Share Attributable to Common Shareholders

Loss per common share attributable to common shareholders is computed by
dividing net loss after deduction of preferred stock dividends, by the weighted
average number of common shares outstanding during the period.

For the years ended December 31, 2000, 1999, and 1998, the Company's potential
common stock equivalents have either an antidilutive or have no effect on loss
per share attributable to common shareholders and, therefore, diluted loss per
common share attributable to common shareholders has not been presented.

The following table summarizes those securities that could potentially dilute
loss per common share attributable to common shareholders in the future that
were not included in determining the fully diluted loss per common share
attributable to common shareholders as there is either no effect or the effect
is antidilutive.


<TABLE>
<CAPTION>
                                                                     Years Ended December 31,
Potential Common Shares resulting from:                        2000           1999           1998
                                                            ---------      ---------      ---------
<S>                                                     <C>            <C>            <C>
Stock Options  (see Note 10)                                2,075,000      2,399,250      1,853,300

Cumulative, Convertible, Redeemable Preferred Stock
                                                                    0              0        300,000
                                                            ---------      ---------      ---------

                                                            2,075,000      2,399,250      2,153,300
                                                            =========      =========      =========

</TABLE>

Comprehensive income (loss)

The Company does not have any comprehensive income items other than net income
for the years ended 2000, 1999 and 1998.

Fair Value of Financial Instruments

The fair value of the Company's financial instruments such as accounts
receivable, accounts payable, and note payable approximate their carrying
amounts.

Carrying Value of Long-Term Assets

The Company evaluates the carrying value of long-term assets, including
property, plant and equipment, and other intangibles, based upon current and
anticipated undiscounted cash flows, and recognizes an impairment when such
estimated cash flows are less than the carrying value of the asset.  Measurement
of the amount of impairment, if any, is based upon the difference between
carrying value and fair value.

New Accounting Pronouncements

In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" (as amended
by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--
Deferral of the Effective Date of FASB Statement No. 133" and SFAS No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging
Activities."). This statement establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts, (collectively referred to as derivatives) and hedging
activities.  It requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure those
instruments at fair value.  The Company adopted this standard in January, 1999,
which had no impact on the Company's financial statements.



                                      F-11
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


In December 1999, the Securities and Exchange Commission (the "SEC")  issued
Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements
("SAB No. 101"). SAB No. 101 provides guidance on the recognition, presentation
and disclosure of revenue in financial statements filed with the SEC, and was
adopted by the Company in the fourth quarter of 2000. The adoption of SAB No.
101 had no material impact on the company's consolidated financial position or
results from operations

Reclassification of Accounts

Certain reclassifications have been made to conform prior years' balances to the
current year presentation.

3. Liquidity and Continuation Of Business

The consolidated financial statements of the Company have been prepared on a
going-concern basis, which contemplates the continuation of operations,
realization of assets and liquidation of liabilities in the ordinary course of
business. The Company incurred a net loss applicable to common shareholders of
approximately $4,763,770 during the year ended December 31, 2000 and had
negative cash flow from operating activities of $1,909,732.  At December 31,
2000 the Company had a net working capital deficit of $3,056,625 and an
accumulated deficit of $15,087,022.  In addition, the Company was not in
compliance with one of its covenants in its Loan and Security Agreement with
Wells Fargo Bank, however, the Company received a waiver related to such non-
compliance.  The Company can renew its line of credit arrangement with Wells
Fargo for one more year on May 11, 2001. The Company does not believe that its
events of non-compliance and subsequent waiver will affect its ability to renew
the line of credit. Such conditions raise substantial doubt about the Company's
ability to continue as a going concern.  The accompanying financial statements
do not include any adjustments that might be necessary should the Company be
unable to continue as a going concern.

The Company plans to focus on growing its revenue base through the addition of
profitable customers and decreasing its network costs.  The Company intends to
reduce its network costs by obtaining more favorable pricing from suppliers, by
forming strategic alliances with certain similarly situated companies,
increasing the network traffic on its fixed cost network, and also discontinuing
the operations located in Oakland California and using a more cost favorable way
to transport that existing traffic.

The Company expanded on its private Internet web sites from which its agents are
generating new orders electronically.  The Company expects to continue its
efforts to expand this strategy in order to generate new business. In addition
to these private Internet sites, the Company plans to implement an electronic
business-to-business strategy to reduce overhead costs associated with operating
its agent sales force channel.

Additionally, the Company began the resale of  local access services to its
current and prospective customers in six Bell Atlantic, now Verizon states under
its favorable interconnection agreements.

On March 15, 2001, the Company entered into a Loan Agreement with Gold & Appel
Transfer, S.A. ("G&A"), a majority shareholder of the Company.  The terms of the
agreement calls for the Company to borrow up to $900,000 at a rate of 12% per
annum, due and payable on June 15, 2002. The agreement allows G&A to convert all
or any portions of the loan amount to shares of the Company's Common Stock at
the average trading price for 20 days up to the conversion date at any given
time during the loan period. The Company borrowed the first $300,000 on March
15, 2001. The remaining two $300,000 borrowings are required to be paid by May
1, 2001 and June 15, 2001 respectively. However, at the Company's option these
borrowings may be made at a later date. This loan agreement violates one of the
restrictions in the Company's $2,000,000 credit facility with Wells Fargo Credit
Corporation. The Company has not yet received a waiver of such condition of non-
compliance.


                                      F-12
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

On March 28, 2001 Gold & Appel, the company's largest shareholder, sold a
majority ownership interest (15,471,301 shares) in the Company at a price of
$.20 per share for a total amount of $3,094,260. The purchaser is the chairman
of another publicly traded telecommunications company. The Company has received
a letter of interest from this other telecommunications company regarding a
possible merger. However there can be no assurances that a merger agreement will
be negotiated in favorable terms to the Company, or that a merger will occur at
all.

The Company believes that the loan agreement, combined with its cost reductions
will be adequate to allow the company to continue its operations, however there
can be no assurances to this effect.

The company was not be able to meet the minimum financial requirements necessary
to maintain its listing on the NASDAQ SmallCap Market.  Management has
determined that utilizing the capital to maintain this list is not in the best
interest of the shareholders, and chose not to raise the additional funds.
Instead management is focusing on raising funds to correct its current cost
structure and also improve its current financial position. Also, in order to
achieve the Company's plans for growth in the long distance business as well as
its entry into other communications services, the Company may require additional
equity and is currently seeking sources of funding. The Company cannot give
assurance as to the potential success of these efforts.

4.  Note Payable

The Company has a revolving $2,000,000 credit facility with Wells Fargo Business
Credit Corporation, which was renegotiated and amended on May 11, 1999 and is
automatically renewable for one more year beginning  on May 11, 2001. Interest
on the revolving credit facility is currently calculated at the prime lending
rate plus 2 3/4%, on a minimum loan balance of $750,000.  The loan is
collateralized by accounts receivable and fixed and intangible assets of the
Company.  As of December 31, 2000, the Company's outstanding balance on its
credit facility was approximately $1,858,673 leaving approximately $141,327
available based on collateral, for future borrowing under the credit facility.

The loan agreement contains covenants and restrictions which, among other
things, require maintenance of certain subjective financial performance criteria
and restrict encumbrance of assets, creation of indebtedness and places
limitations on annual capital expenditures. The Company was not in compliance
with one of its covenants in the Loan and Security Agreement, however, the
Company received a waiver related to such condition of non-compliance at
December 31, 2000.

At December 31, 2000 and 1999  the Company maintained a letter of credit with
First Union Bank in the amount of $752,000 for the potential settlement of
litigation related to Mr. Scully. The letter of credit is collateralized by cash
on deposit with First Union Bank in the amounts of $823,571 and $770,363 at
December 31, 2000 and 1999 respectively. The letter of credit was released by
First Union on February 28, 2001 upon settlement of the aforementioned
litigation. (See footnote 12).

5.  Obligations Under Capital Leases

Property under capital leases is recorded at the lesser of the present value of
the minimum lease payments or its fair value at inception. The Company leases
various equipment under three-to-five-year non-cancellable leases which expire
at various dates through 2000.

The leases carried interest rates ranging from approximately 9.0% to
approximately 13.5% and are collateralized by the equipment purchased. All of
the these obligations were paid in 2000.

The aggregate capital lease obligations at December 31, 1999 were $162,251 of
which $8,962 represented interest leaving a net present value of $153,289 all of
which was paid in 2000.



                                      F-13
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


The following is an analysis of property under capital leases:

                                     2000        1999
                                     ----        ----

Telecommunications Equipment       $1,300,951  $1,300,951
Office Equipment                       22,512      22,512
                                   ----------  ----------
 TOTAL                              1,323,463   1,323,463

Less Accumulated Amortization       1,066,112     855,669
                                   ----------  ----------
 Net Assets Under Capital Lease    $  257,351  $  467,794
                                   ==========  ==========

Amortization of assets under capital leases charged to operations and included
in depreciation expense was $210,443 per year in 2000 and 1999.

6.  Income Taxes

The net deferred tax asset at December 31 includes the following:

                                                 2000          1999
                                                 ----          ----

Deferred Tax Asset                            $ 5,409,000   $ 3,470,000
Deferred Tax Liability                           (140,000)     (138,000)
Valuation Allowance for Deferred Tax Asset     (5,269,000)   (3,332,000)
                                              -----------   -----------
                                              $        --   $        --
                                              ===========   ===========

The utilization of the deferred tax asset depends on the Company's ability to
earn taxable income in the future. Although estimates are subject to change,
management was not able to determine that utilization of the deferred tax asset
is likely. Accordingly, a valuation allowance has been provided for the entire
deferred tax asset. The tax effect of major temporary differences that gave rise
to the Company's deferred tax assets and liabilities at December 31 are as
follows:


                                            2000          1999
                                            ----          ----

Net Operating Loss and Carryforwards    $  4,456,000   $ 2,412,000
Allowance for Doubtful Accounts              422,000       716,000
Legal and Commission Reserves                531,000       334,000
Charitable Contributions                          --            --
Depreciation                                (140,000)     (138,000)
AMT Credit                                        --         8,000
                                        ------------   -----------
Net Deferred Tax Asset                     5,269,000     3,332,000
                                        ------------   -----------
Valuation Allowance                       (5,269,000)   (3,332,000)
                                        ------------   -----------
Total                                   $         --   $        --
                                        ------------   -----------


                                      F-14
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The provision for income tax expense (benefit) for the years ended December 31,
consisted of the following amounts:


                                  2000      1999        1998
                                  ----      ----        ----
Current tax expense (benefit)
 Federal                         $  --     $  --     $10,000
 State                              --        --          --
                                 -----     -----     -------
                                    --        --      10,000

Deferred tax expense
   Federal                          --        --          --
 State                              --        --          --
                                 -----     -----     -------
                                 $  --     $  --     $10,000
                                 =====     =====     =======

The differences between the Company's income tax expense (benefit) and income
tax expense (benefit) computed using the U.S. Federal Income Tax rate were as
follows:
<TABLE>
<CAPTION>
                                  2000                 1999                  1998

                                              % of                 % of                  % of
                                             pretax               pretax                pretax
                                 Amount      income    Amount     income    Amount      income
<S>                           <C>            <C>     <C>         <C>      <C>           <C>
Computed "expected" income
 tax expense (benefit)        $( 1,496,000)  (34.0)  $(989,000)   (34.0)  $(1,209,000)   (34.0)
Valuation allowance              1,496,000    34.0     989,000     34.0     1,219,000     34.5
Other                                    0       0           0        0             0        0
                              ------------   -----   ---------    -----   -----------    -----
Actual income tax
 expense (benefit)            $         --      --   $      --       --   $    10,000       .5
                              ============   =====   =========    =====   ===========    =====
</TABLE>

The Company has available approximately $10,127,000 of net operating loss carry
forwards which may be applied against future federal taxable income. These carry
forwards begin to expire in 2006.


7.  Commitments and Contingencies

On September 26, 2001 the Company has extended, per Amendment No.31 a long term
contract for the purchase of 1+. 800 and Private line services with its primary
underlying carrier Worldcom. The contract provides for a minimum monthly
commitment of $150,000 and an aggregate commitment of $3,600,000 over the 24-
month contract life. The contract converts to a month-to-month agreement at the
point-in-time the Company achieves the total minimum revenue commitment of
$3,600,000. The Company estimates that it will achieve its minimum revenue
commitment sometime during the third quarter 2001.


                                      F-15
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company leases certain offices and equipment under operating leases. Future
annual minimum lease payments under the significant agreements are as follows
for the years ended December 31:

                     2001              456,498
                     2002              429,102
                     2003              362,531
                     2004              276,951
                     2005               93,136
                     thereafter        232,200
                                    ----------
                      TOTAL         $1,850,418
                                    ==========

Rent expense incurred for operating leases was approximately $450,902, $482,771,
and $492,789 in 2000, 1999, and 1998, respectively.

The Company entered into a contract in December 1996 with its former Chairman
for consulting services.  The total minimum aggregate commitment level over the
remaining two years of contract as of December 31, 2000 is approximately $
269,223.

8.   Pension Plans

The Company sponsors a defined contribution 401(K) Pension and Profit Sharing
Plan for all employees.  The Company has elected to match 50% of the employees
contribution with a maximum of 4% of the employees salary. The expense related
to this plan for 2000 was $41,554.

10.  Common Stock, Stock Options and Warrants

Under the Company's stock option plans, options may be granted to officers and
employees of the Company and its subsidiaries.  No option may be granted for a
term in excess of ten years from the date of grant.  As of December 31, 2000,
1,881,000 of the outstanding stock options were exercisable under the plans.
The exercise prices of the outstanding options represented the fair market value
at dates of grant.  In November 1999, the shareholders approved an amendment to
the Company's Certificate of Incorporation to adopt a new stock option plan by
the Company that would permit the grant of options for a total of  3,000,000
shares of common stock. The options vest at various times over periods ranging
up to two years. The options, if not exercised expire up to 5 years after the
date of grant.

A summary of the Company's stock option plans activity for common shares for the
three years ended December 31, 2000 follows:

                                              Options      Average
                                            Price Range    Exercise
                        Number of Shares     Per Share      Price
                        ----------------   --------------  --------
Outstanding 12/31/97           2,442,834   $1.00 to $2.25     $1.28
     Granted                     516,750   $1.19 to $2.38     $1.20
     Exercised                (1,068,984)  $1.00 to $1.53     $1.31
     Terminated                  (37,300)  $1.00 to $2.00     $1.33
                              ----------   --------------     -----
Outstanding 12/31/98           1,853,300   $1.00 to $2.38     $1.28
     Granted                   1,046,000   $1.38 to $2.22     $1.55
     Exercised                  (398,800)  $1.00 to $1.53     $1.05
     Terminated                 (101,250)  $1.00 to $2.22     $1.35
                              ----------   --------------     -----
Outstanding 12/31/99           2,399,250   $1.00 to $2.38     $1.43
     Granted                     224,500   $1.00 to $2.50     $1.52
     Exercised                   (21,500)  $1.00 to $1.19     $1.24
     Terminated                 (527,250)  $1.16 to $2.50     $1.81
                              ----------   --------------     -----
Outstanding 12/31/00           2,075,000   $1.00 to $2.38     $1.37
                              ==========   ==============     =====


                                      F-16
<PAGE>

   CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
                                   Options Outstanding             Options Exercisable
                         ---------------------------------------  ---------------------
                                      Weighted  Weighted Average               Weighted
                                      Average      Remaining                   Average
       Range of                       Exercise    Contractual                  Exercise
   Exercised Prices      Outstanding   Price     Life in Years    Exercisable   Price
-----------------------  -----------  --------  ----------------  -----------  --------
<S>                      <C>          <C>       <C>               <C>          <C>

     $1.00 - $1.16           360,000     $1.03              3.01      350,000     $1.03
     $1.19 - $1.30           641,000     $1.24              2.46      605,500     $1.24
     $1.38 - $1.75         1,038,500     $1.55              3.26      925,250     $1.55
     $1.78 - $2.22            35,500     $1.88              2.09          250     $2.22
                           ---------     -----              ----    ---------     -----
                           2,075,000     $1.37              2.95    1,881,000     $1.36
                           =========     =====              ====    =========     =====
</TABLE>


Employee Stock options

The Company accounts for stock options issued to employees in accordance with
Accounting Principles Board Opinion No. 25, under which compensation cost is
recognized based on the difference, if any, between the fair value of the
Company's stock at the time of option grant and the amount the employee must pay
to acquire the stock.  The Company's options have been issued at fair market
value at the time of grant.  Had compensation cost for the incentive and non-
qualified options been determined consistent with Statement of Financial
Accounting Standards No. 123, Accounting for Stock - Based Compensation (SFAS
123), the Company's pro forma net loss and net loss per share for the years
ended December 31 are as follows:

                                   2000           1999           1998
                                -----------    -----------    -----------
Reported Net Loss               $(4,763,770)   $(2,964,399)   $(1,855,369)
Proforma Net Loss               $(5,206,796)   $(3,137,115)   $(2,040,115)
Reported Net Loss Per Share     $      (.22)   $     (0.15)   $     (0.10)
Proforma Net Loss Per Share     $      (.24)   $     (0.16)   $     (0.11)

In accordance with the requirements of SFAS 123, this method of accounting has
not been applied to options granted prior to the fiscal year beginning January
1, 1995.  The resulting pro forma compensation cost may not be representative of
that to be expected in future years.

The weighted fair value of options granted during Fiscal 2000, 1999 and 1998 was
$.53, $.63 and $.69 respectively.  The fair value of each stock option grant is
estimated on the date of grant using the Black-Scholes option pricing model with
the following weighted average assumptions used for grants in 2000, 1999 and
1998: risk-free interest rates of 6.5%, 5.7% and 6.5% respectfully, expected
dividend yields of 0%, expected lives ranging from two to five years from the
date of grant, and expected price volatility between 35% and 70% for the options
granted in 2000, 1999 and 1998.

During 2000, the Company issued stock options to employees to purchase Common
Stock at below fair market value for which the Company recorded $10,403 in
selling, general and administrative expense.  Also the Company extended the life
of certain options to employees for which it recorded $130,939 in selling,
general and administrative expense.


                                      F-17
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Third Party Stock Options

The Company accounts for stock options issued to outside consultants in
accordance with SFAS 123, under which compensation expense is recognized based
on the difference, if any, between the fair value of the award or the goods or
services received, whichever is more reliably measurable.  The Company has
measured the options based on the fair value of the award and the amount that
the outside consultant must pay to acquire the stock at the date of grant due to
its inability to reliably measure the fair value of the goods or services.

During 1998, the Company issued 143,750 options to purchase Common Stock to
three independent contractors.  The options entitle one contractor to purchase
100,000 shares at $2.375 per share, another contractor to purchase 25,000 shares
at $1.1875 per share and the last contractor to purchase 18,750 shares at
$1.1875 per share.  In 1998, the Company recorded approximately $133,000 in
Selling, General and Administrative expenses associated with these options.

There are no outstanding warrants as of December 31, 2000.

11.  Cash Flow Information

Supplemental Disclosure of Cash Flow Information

The Company made cash payments for interest of $ 164,851 , $181,197, $232,915
for the years ended December 31, 2000, 1999, and 1998, respectively. The Company
made cash payments for income taxes of $0, $0 and $10,000 for the years ended
December 31, 2000, 1999, and 1998, respectively.

Supplemental Disclosure of Non-Cash Investing and Financing Activities

On August 31, 1999, the Company purchased certain assets of JMR Marketing
Corporation including a customer base, property and equipment and sales
contracts associated with certain Affinity Groups in exchange for 150,000 shares
of common stock, with a fair market value of $262,000.

On July 1, 1999, the only preferred shareholder converted 30,000 shares of
preferred stock to 300,000 shares of common stock.

12.  Litigation

On June 13, 1997, Mark Scully, a former President and Chief Operating Officer of
the Company, filed a complaint against the Company, Kevin O'Hare, Aaron Brown
and Stephen Parker in the United States District Court for the Eastern District
of Pennsylvania.  Mr. Scully asserted various claims in connection with his
termination of employment with the Company on December 30, 1996.  In particular,
he alleged, among other things, breach of contract in connection with the
termination of certain stock options, breach of the alleged contract for
employment, breach of an asserted duty of good faith and fair dealing,
fraudulent and negligent misrepresentation, and civil conspiracy.  Mr. Scully
alleged damages of at least $1.6 million, plus attorneys' fees, costs and other
disbursements and the cost of COBRA payments and interest; $1 million of the
alleged damages claimed are punitive. On June 9, 1999, the Court issued its
decision and judgment was entered in favor of Mr. Scully and against the Company
and two former officers for the sum of approximately $626,000 and required the
Company to establish an escrow account equal to 120% of the judgment.  The Court
denied Mr. Scully's claim for attorneys' fees and liquidated damages. The
Company appealed the decision, and on February 1, 2001 the appeals court
reaffirmed the lower court's decision and judgment was entered in favor of Mr.
Scully and against the Company and two former officers for the sum of $1,080,000
which consisted of the original award of $626,443 in damages plus legal expenses
and interest. The Company ultimately settled with Mr. Scully for $1,030,000.


                                      F-18
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The company recorded expense for this litigation of $404,000, $326,000 and
$300,000 for 2000, 1999 and 1998 respectively. In 1999 the Company was required
to establish an escrow account to provide for damages, and the balance in these
escrow accounts at December 31, 2000 and 1999 was $823,571 and  $770,363
respectively, and is recorded as restricted cash.

The Company is party, in the ordinary course of business, to other litigation
involving services rendered, contract claims and other miscellaneous causes of
action arising from its business.  The Company has established reserves relating
to its legal claims and believes that potential liabilities in excess of those
recorded will not have a material adverse effect on the Company's Consolidated
Financial Statements, however, there can be no assurances to this effect.

13.  Related Party Transactions

Indemnification Arrangements

The Company is party to indemnification agreements with two of its directors,
Aaron R. Brown and Stephen J. Parker, dated August 1990.  In addition, the
Company has entered into an indemnification agreement with Kevin O'Hare, a
former executive officer of the Company, dated July, 1997.  In general, the
indemnification agreements obligate the Company to indemnify each of Messrs.
Brown, Parker and O'Hare against the liabilities and expenses incurred by them
in acting as a director or officer of the Company to the maximum extent allowed
by law.  As stated above, the Company, together with Messrs. Parker, Brown and
O'Hare, have been sued by a former president for various claims asserted by the
plaintiff in connection with his termination of employment with the Company on
December 30, 1996. The Board of Directors has authorized the Company to advance
the expenses of the individual defendants incurred in defending this action upon
the receipt of an undertaking from each of them to repay the amounts so advanced
in the event it is determined that they are not entitled to indemnification
under applicable law.  As of December 31, 2000, no amounts had been advanced by
the Company under such agreements. As a result of the settlement with the Mr.
Scully (See Note 14), Messrs. Brown, Parker and O'Hare have been release from
all liability regarding the litigation brought forth as referenced above.

Sales Agency

Mr.Goldberg, a director of the Company, acts as a sub-agent for the Company and
is the co-owner of Goldberg & Associates, a company that acts as an agent for
the Company in the sale of products and services.  During 2000, the Company paid
Mr. Goldberg and such company a total of $ 42,961 in commissions for their
services as sales agents.  Commissions paid to Mr. Goldberg and such company
were at competitive rates.

Private Placement

On March 22, 2000, the Company entered into a Loan Agreement with Gold & Appel
Transfer, S.A. ("G &A"), a major shareholder of the company, and the Foundation
for the International Non-Governmental Development of Space, a non-profit
organization ("FINDS"), a shareholder of the Company of which Mr. Anderson is
the president and director.  The terms of the agreement call for the Company to
borrow up to $1,000,000 from G&A and $500,000 from FINDS at a rate of 10% per
annum and due and payable on March 1, 2001.   The agreement included that all
parties may convert all or any portions of the loan amount to shares of the
Company's Common Stock valued at 90% of the average Market Price, with such
average computed based on the 30 day trading period preceding the date of this
agreement or $2.50 per share.. As a result of this beneficial agreement,
$215,217 was charged to interest expense upon issuance. This agreement was
amended on May 19 as set forth in the following paragraph

                                      F-19
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

On May 19, 2000, the Company through a private placement transaction, issued
666,667 shares of common stock to G&A, a majority shareholder of the Company,
and 333,333 shares of common stock to FINDS, a shareholder in the Company, in
full payment of a loan obligation with an original principal amount of
$1,500,000 respectively.  The terms of such transaction were negotiated between
the Company, G&A and FINDS on an arms length basis, with Mr. Anderson, the
controlling party of G&A and a director of FINDS, abstaining from all
negotiations.

On June 30, 2000 the Company through a private placement transaction, issued
720,000 shares of common stock to Gold & Appel Transfer, S.A., a majority
shareholder of the Company, for an aggregate purchase price of $900,000 or $1.25
per share. The proceeds of the issuance are being used for general working
capital.  The terms of such transaction were negotiated between the Company and
Gold & Appel Transfer, S.A. on an arms length basis, with Mr. Anderson
abstaining from all negotiations and approvals.

Acquisition

On March 17, 2000, the Company purchased certain assets of the business of Cam-
Comm, Inc. At the time of the transaction, James Rossi was the chairman of the
Company and owned Cam-Comm. The Company acquired the customer base and accounts
receivable of $83,876 private line customers from Cam-Comm, Inc. in exchange for
a cash payment of $150,000 and an agreement to pay an amount of $76,405 for an
outstanding liability of Cam-Comm, Inc. Goodwill of $142,529 was recorded and
will be amortized over three years.

14.  Subsequent Events

On January 25, 2001 the Company terminated its pending merger agreement with
Startec Global Communications. Subsequent to the termination the Company and
Startec entered into an agreement which provides for Startec to make a series of
payments totaling $400,000 for the Company's expenses associated with the
proposed merger. The first payment of $100,000 was received on March 9, 2001.
Three subsequent $100,000 payments are due 60 days from the prior payment. The
Company will record the effect of these payments when received.

On February 28, 2001 the Company settled its outstanding litigation with Mark
Scully for an amount of $1,030,000 for damages arising from the termination of
his employment with the Company. The amount is allocated for settlement of the
following items: $626,443 for damages arising from Scully's termination, $53,747
in interest on the aforementioned damages, and $349,810 in Mr. Scully's legal
expenses.  The settlement releases all parties from any further claims. The
expense recorded for this litigation was $404,000, $326,000 and $300,000 in
2000, 1999 and 1998 respectively.

On March 15, 2001, Company entered into a Loan Agreement with Gold & Appel
Transfer, S.A. ("G&A"), a majority shareholder of the company.  The terms of the
agreement calls for the Company to borrow up to $900,000 at a rate of 12% per
annum, due and payable on June 15, 2002.  The agreement allows G&A to convert
all or any portions of the loan amount to shares of the Company's Common Stock
at the average trading price for 20 days up to the conversion date at any given
time during the loan period. The Company borrowed the first $300,000 on March
15, 2001. The remaining two $300,000 borrowings are required to be paid by May
1, 2001 and June 15, 2001 respectively. However, at the Company's option these
borrowings may be made at a later date. This loan agreement violates one of the
restrictions in the Company's $2,000,000 credit facility with Wells Fargo Credit
Corporation. The Company has not yet received a waiver of such condition of non-
compliance.

On March 5, 2001 the Company announced that it received notification from NASDAQ
on February 26, 2001 that the Company was no longer in compliance with the
minimum net tangible assets requirements for continued listing on The NASDAQ
SmallCap Market set forth in Marketplace Rule 4310(c)(2)(B). The NASDAQ Staff
had therefore determined to delist the Company's securities from The NASDAQ
SmallCap Market at the opening of business on March 6, 2001. The Company
determined not to appeal the NASDAQ Staff's determination, and therefore,
effective March 6, 2001, the Company's securities began to trade on the OTC-BB
under the symbol "CAPS.OB."


                                      F-20
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

On March 28, 2001 Gold & Appel, the company's largest shareholder, sold a
majority ownership interest (15,471,301 shares) in the Company at a price of
$.20 per share for a total amount of $3,094,260. The purchaser is also the
chairman of another publicly traded telecommunications company. The Company has
received a letter of interest from this other telecommunications company
regarding a possible merger. However, there can be no assurances that a merger
agreement will be negotiated on favorable terms to the Company, or that a merger
will occur at all.

15. Other Sales Information

Net sales information by the Company's product groups for the years ended
December 31 are summarized as follows:

<TABLE>
<CAPTION>
                                               2000               1999               1998
                                               ----               ----               ----
                                             Amount    %        Amount    %        Amount    %
                                             ------             ------             ------
<S>                                     <C>          <C>   <C>          <C>   <C>          <C>
Domestic 1+                             $20,743,306   56   $19,093,119   48   $20,105,578   45
International                             8,367,635   22     8,751,013   22    10,276,183   23
Inbound                                   5,722,538   15     6,762,146   17     6,701,859   15
Wireless                                    793,664    2     1,193,320    3     1,787,162    4
Domestic Carrier Termination              1,493,339    4     3,977,733   10     5,808,278   13
Local                                       247,881    1            --   --            --   --
                                        -----------  ---   -----------  ---   -----------  ---
    Total                               $37,368,363  100%  $39,777,331  100%  $44,679,060  100%
                                        ===========  ===   ===========  ===   ===========  ===
</TABLE>

All of the Company's operations are conducted in the United States of America.


                                      F-21
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


16. Quarterly Financial Information

<TABLE>
<CAPTION>

2000                                               First        Second       Third        Fourth       Total
                                                  Quarter      Quarter      Quarter      Quarter        Year
                                                 ----------   ----------   ----------   ----------   ----------
<S>                                              <C>          <C>          <C>          <C>          <C>
Revenues                                          8,733,562    9,563,398    9,736,092    9,335,307   37,368,359

Loss before depreciation and amortization          (811,056)    (728,286)    (852,507)  (1,363,875)  (3,755,724)

Depreciation and amortization                       259,380      537,720      773,940    1,008,046    1,008,046

Net Loss                                         (1,070,436)  (1,006,626)  (1,088,727)  (1,597,981)  (4,763,770)

Net loss per share of common stock                     (.05)        (.05)        (.05)        (.07)        (.22)
</TABLE>

<TABLE>
<CAPTION>
1999                                               First       Second        Third       Fourth       Total
                                                  Quarter      Quarter      Quarter     Quarter       Year
                                                 ----------  -----------  -----------  ----------  -----------
<S>                                              <C>         <C>          <C>          <C>         <C>
Revenues                                          9,185,562   10,236,754   10,827,823   9,527,192   39,777,331

Loss before depreciation and amortization          (296,128)    (491,582)    (523,121)   (584,239)  (1,895,070)

Depreciation and amortization                       374,435      287,022      165,427     242,445    1,069,329

Net Loss                                           (670,563)    (778,604)    (688,548)   (826,684)  (2,964,399)

Net loss per share of common stock                     (.04)        (.04)        (.03)       (.04)        (.15)
</TABLE>

                                      F-22
<PAGE>

    CAPSULE COMMUNICATIONS, INC. (FORMERLY U.S. WATS, INC.) AND SUBSIDIARIES
                Schedule II - Valuation and Qualifying Accounts


<TABLE>
<CAPTION>
COL. A                                     COL. B          COL. C              COL. D         COL. E        COL. F
---------------------------------------------------------------------------------------------------------------------
DECRIPTION                               BALANCE AT                          CHARGED TO      DEDUCTIONS-   BALANCE AT
                                          BEGINNING        CHARGED TO      OTHER ACCOUNTS-     ACCOUNTS       END OF
                                          OF PERIOD          EXPENSE          RECOVERIES      WRITTEN OFF     PERIOD
---------------------------------------------------------------------------------------------------------------------
Period ended 12/31/00
---------------------
<S>                                      <C>               <C>              <C>             <C>            <C>
ALLOWANCE FOR DOUBTFUL
  ACCOUNTS-                              $1,711,853           $  714,921       $  3,970      $(1,242,506)   1,188,238
  ACCOUNTS RECEIVABLE

---------------------------------------------------------------------------------------------------------------------
Period ended 12/31/99
---------------------

ALLOWANCE FOR DOUBTFUL
  ACCOUNTS-                              $  934,624           $1,453,496       $ 67,797      $  (744,064)  $1,711,853
  ACCOUNTS RECEIVABLE

---------------------------------------------------------------------------------------------------------------------
Period ended 12/31/98
---------------------

ALLOWANCE FOR DOUBTFUL
  ACCOUNTS-                              $1,498,749           $  788,493       $(18,763)     $(1,333,855)  $  934,624
  ACCOUNTS RECEIVABLE

---------------------------------------------------------------------------------------------------------------------
</TABLE>

                                      F-23